Warning pure focus on fees ‘misleading’ and ‘dangerous’

Investors need to look beyond the headline total expense ratio (TER) to other metrics when selecting an ETF if they want to avoid potential marketing traps.

The race to the bottom and beyond has been taken to another level on both sides of the pond. In the US, Fidelity launched the first zero expense ratio index funds last summer while Salt Financial went one further on 12 March by filing to launch an ETF that pays investors for owning it, the Salt High truBeta US Market ETF (SLT).

European ETF providers have also been capturing the headlines by slashing fees at a remarkable rate. Last March, Lyxor launched two ETFs as part of its core range at 0.04%, the lowest across Europe, while Amundi’s new Prime suite is entirely priced at 0.05%.

There is no doubt lower fees are benefiting investors however, returns are not derived purely from the total expense ratio (TER) meaning other metrics should be taken into account.

Ben Johnson, director of passive funds research at Morningstar, said the latest moves in the fee war would more benefit fund firms and affiliated brokerages than the end investor.

“The amount of free publicity these fund launches and fee reductions have garnered has likely paid dividends for [the firm’s] sponsors.

“And in some cases, like Fidelity’s zero-fee suite, these funds are clearly loss leaders, a cheap gallon of milk meant to entice consumers into the back of the store in hopes that they will grab some Cheetos and a pack of gum before they get to the counter.”

For Simon Klein, head of passive investments, EMEA and Asia at DWS, choosing the right index provider is the most important factor when considering a variety of ETFs to invest in.

The reason why it has been very hard for active managers to beat traditional benchmarks such as the S&P 500 or FTSE 100 is because their index construction is so good.

One only has to look at S&P Dow Jones Indices’ 2018 US SPIVA scorecard results, which came out on 12 March, to show how much managers have struggled over the years against the S&P 500. 2018 was the ninth year in a row the majority of active managers failed to beat the flagship benchmark.

He added a non-standard benchmark, which charges a flat fee, may enable ETF providers to launch a cheaper product however, investors might not see the best performance.

“It is important to work with establish providers such as MSCI and FTSE Russell as they have shown over the years it is difficult to beat their benchmarks.

“Pure focus on cost is a misleading and dangerous development in the ETF industry,” Klein warned. “The discussion we have with clients is not about a few basis points here or there but rather about choosing the right index.”

Other metrics investors should take into account when selecting an ETF Klein highlighted are the tracking methodology – whether they replicate the entire benchmark or select a basket of securities at a cheaper rate – and how the firm creates efficiencies in the market such as securities lending and corporate action.

Where the ETF is listed is also major factor. Peter Sleep, senior investment manager at 7IM, said as a general rule for tax purposes, UK investors should always ensure the ETF is domiciled in Ireland and has UK tax reporting status.

For example, a US equity product listed in Luxembourg will have to pay far more tax on dividends earned than if it was listed in Ireland.

Another issue investors should consider, Sleep said is whether the ETF is physically or synthetically backed. The trend in recent years is for providers to launch ETFs that are physically replicated.

“Once you have thought about these issues then you can start to think about long term tracking difference and fees.

“Fees are one of the biggest contributors to tracking error so they are clearly important,” he continued. “However, the major contributor is tax.”

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