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Are ETFs really value for money?

by Rob Griffin on May 02, 2011 at 00:01

Are ETFs really value for money?

In the world of fund management, it is a debate that refuses to go away – should passive investors stick with traditional mutual fund trackers or are they better served by opting for an exchange traded fund?

On the face of it, these products are pretty similar. Both offer investors a way of tracking specific indices, which has become an increasingly popular option for those that have lost faith and money with active managers.

Dan Draper, head of ETFs at Credit Suisse, agrees trackers and ETFs have common ground.

‘The fact is, an ETF is still an index fund, just one that is listed on a stock exchange,’ he says. ‘The real difference between the two is that an ETF has a liquidity advantage because it is traded like a share.’

This is the basic crux of the argument: due to the ways in which they operate, trackers and ETFs will suit different types of passive investor.

Deciding which route is most suitable for a particular client will largely come down to that individual’s investment time horizons.

So what do these passive investors want from an index tracker?

According to Andy Gadd (pictured), head of research at Lighthouse Group, it is relatively cheap exposure to various markets and indices around the world.

‘Even the most experienced investor can benefit from having a tracker as part of their core portfolio for one simple reason: cost,’ he says.

‘Unlike active funds, you are not paying for a skilled bank of analysts – it is effectively a black box approach.’

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8 comments so far. Why not have your say?

John Blackmore

May 02, 2011 at 14:13

For the investor the problem comes with both ETF and traditional tracker when rather than paying for a "skilled bank of analysts" in an actively managed fund he he opts for an adviser enthusiast who uses a wrap or platform with additional charges. The extra cost of the adviser and the wrap can quite easily result in little if any difference in cost between active and passive.

The cost argument in favor of passive really only applies if no advice is taken and if no additional platform charges are made. Otherwise the investor might as well follow the traditional active road.

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Chris Wicks CFP

May 02, 2011 at 15:41

John makes a valid point regarding charges, up to a point. However to suggest that where the charges are the same, investors might as well stick to the 'traditional active' road misses the point that 'active' strategies which generally rely on market timing & stock selection strategies are fundamentally flawed and usually fail to out perform the markets in which they are invested. It also fails to take account of the extremely poor persistency of the performance of 'good' active managers. The point being that there is virtually no case for active fund management because the chances of being rewarded for paying extra are pretty slim and even where the costs are the same, the active fund manager is likely to commit errors which will result in performance that significantly deviates from the market.

This is obviously a more complex topic than can be covered in a quick comment here but to cut a long story short the name of the game should actually be get the asset allocation right first followed by passive/trackers to gain market exposure.

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John Blackmore

May 02, 2011 at 16:06

Chris - agree that it is a complex topic and not easily covered.

would be interested though to see some long term comparison of say (1) random portfolio of actives and (2) ETFs or trackers + the now normal 1% pa adviser "fee" + say 0.5% pa platform cost.

comparisons always see to simply compare passive with active showing that X% of the time passive wins. Has anyone conducted a serious long term study with advice and platform costs added to the passive side of the equation ?

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Stuart Fowler

May 02, 2011 at 19:53

In general, institutional units in the leading trackers in large liquid markets will be quite a bit cheaper than ETFs, taking into account charges and spreads. This cost advantage will survive if the platform used for either asset is low-cost and not portfolio value based. Tracking error, note, need not be a significant consideration between either trackers or physical versus synthetic ETFs.

However, ETFs (traded in or out of local market hours and with currency markets always live) offer advantages in transactional efficiency and clarity (relative to unknown forward prices of unit trusts) that may justify the extra cost.

Logically, managers will use both: a stock of ETFs on a cheap execution-only broker platform for rebalancing and a stock of instituional units for passive long-term holdings, either directly held or on a low-cost flat-rate platform. This maximises cost effectiveness across the whole portfolio.

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Stewart Aldcroft

May 04, 2011 at 07:17

Why so much emphasis on costs?

Yes, it is accepted that ETFs are generally cheaper than traditional funds, and most index funds too, but in my 30+ years in this industry of one thing I am certain. To make the selection of a fund product based on the costs, is guaranteed to lead to a poor result.

In my view, it makes a lot of sense for investors to incorporate a package of both ETFs and/or index trackers, and traditional funds. In the past this was not always possible, partly due to the desire to be remunerated, on the part of the adviser, but now with fee-for-service advice, exclusion of ETFs could rank as bad advice.

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John Blackmore

May 04, 2011 at 07:39

Sorry Stewart but your last sentence confuses me. Are you saving that "fee-for-service" means that we can ignore this cost and go on pretending that passives are cheaper ?

Surely passives are only cheaper if the investor invests without the benefit of advice ? I would have thought that any comparison would have to look at total cost - ETF cost, adviser cost, platform cost ?

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Stuart Fowler

May 04, 2011 at 10:35

Some clarity needed here. The thread started as a comparison of ETFs and index-tracking unit trusts or OEICs and implicitly therefore assumes a prior choice has been made between active and passive means of gaining desired market or beta exposures.

That choice can indeed stand on its own, as a generalisation about the chances of recovering the costs of alpha hunting (depending on your views of market efficiency, perhaps), the reward for the additional risk of alpha hunting and the behavioural effects of alpha hunting (new temptations to destroy value systematically, when assuming past relative performance is predictive rather than random, by buying top performers and locking in underperformance when they revert to the mean more or less randomly).

However, there is a case under RDR, when advice is separated, that the choice should be seen to have been made by the firm as a strategic one - reflecting the belief system of the firm. Many firms like my own have chosen to do this and firms using Dimensional have also made a strategic decision that they then actively promote as a core belief.

Even if firms do not do that, clients might decide for them and make their own selection as a prior when choosing between advisers.

This seems increasingly likely as, after RDR, they will have a clearer choice as to what third party costs they load onto the known advice costs and admin/platform/transaction costs. There is some connection between those two categories but only in the sense that the higher their combined cost (which in some business models like DFM may still be bundled) the more likely the client is to cap total costs by opting for an adviser who prefers passive. This is the only sense in which it is helpful to look at total costs when some are avoidable and some are not.

It is a moot point whether a firm making that strategic decision about implentation vehicles fall foul of the independence' tests. If it did, the FSA would have shot itself in the foot. After all, it introduced the new rules on charging specifically to encourage unbiased selection, consistent with its own long-held conviction that commission and commission offset both led to a bias to active funds.

Incidentally, in the US institutional market, where no such biases exist and the incremental costs of alpha hunting are actually much lower than in retail, the share of passive is over 40%.

There is another generalised way to look at the implentation choice but it also requires separation of beta and alpha. This to view active implementation choices of desired market exposures as an option on alpha. This could satisfy a 'desire to play' and help rationalise it even in the presence of acceptance of high degrees of market efficiency or of agnosticism. However, there should still be a cost budget for the amount of option money paid for alpha hunting and it is hard to see it jutifying the current dominance of active funds.

My earlier post on the question as asked treated platform costs as independent of the product but only because I specifically referred to flat-rate platforms. If value-based platforms are more or less expensive than flat rate for clients as a function of size, then the choice of platform model affects the comparison. But I would argue that in that case the firm has some justifcation to do for its choice of platform rather than for its choice of investment.

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Sebastiano Costa

May 06, 2011 at 11:50

I suggest to read the Antti Petajisto's papers about cost of indexing, active share and performance of mutual funds.

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