ETFs offer yet more choice for fund investors

The growth in exchange-traded funds (ETFs) is giving fund investors yet more choice in a marketplace where thousands of unit trusts, investment trusts and open-ended investment companies (Oeics) are already on offer.

There are some 300 ETFs listed on the UK stock market, with iShares the biggest provider, and there is continuing price competition: last week saw Credit Suisse undercut rivals by launching an ETF tracking the FTSE 100 index for total annual costs of just 0.33 per cent.

Barclays Stockbrokers, the UK’s biggest retail share dealing service, recently reported a 52 per cent annual increase in ETF investment volumes. But other index trackers and traditional, actively managed funds – which aim to beat, not match, market performance – could still be the right choice for many investors.

ETF advocates say they combine the attractions of low-cost tracking of a wide choice of markets and indexes with the real-time pricing of a quoted share – in contrast to unit trusts, where investors can generally deal only once a day.

Justin Modray of financial website says the biggest plus of ETFs is the breadth of investment options they offer. As well as stockmarket indexes, there are ETFs for tracking the performance of high-yielding shares, gold and other commodities, and even for benefiting from market falls through index “shorting”.

Most ETFs also quote low annual charges – total expense ratios (TERs) – of between 0.25 and 0.75 per cent, compared with actively-managed unit trust costs of between 1 and 2 per cent a year.

Supporters of index tracking argue that actively managed funds do not justify their extra costs with better performance, particularly over the longer term. And where managers do outperform, they struggle to deliver consistently above-average returns. By contrast, trackers simply aim to follow the performance of a market benchmark – and generally do so more reliably.

James Norton, director of Evolve Financial Planning, which offers managed portfolios of index-tracking funds, says: “We’re not anti-active funds for the sake of it, but the additional cost is not outweighed by extra gains.”

This extra cost “headwind” for active managers can amount to 2 percentage points annually. However, Norton adds that, for most investors, the ability to buy and sell ETFs at any point in the stockmarket day is “irrelevant” and that they would be better off in other low-cost tracker funds.

“Institutional Oeics are better value than ETFs – they can be less than half the price,” he says.

He points to funds from Vanguard, the US manager that launched in the UK a year ago, which include a FTSE All-Share tracker with a TER of just 0.15 per cent a year, while the cheapest All-Share ETFs charge about 0.4 per cent.

Even this small annual cost discrepancy could compound to a significant difference in returns for a long-term investor saving for retirement. A £25,000 investment earning a 7 per cent annual return would grow to £178,000 after 30 years in the tracker charging 0.15 per cent, he calculates, compared with £160,000 in an ETF charging 0.4 per cent.

While Vanguard’s funds often require a minimum investment of £100,000, they can be bought via Dundee-based Alliance Trust, for example, at any size.

ETFs carry other costs, too. Although investors do not pay stamp duty, the average spread between buying and selling prices is 0.6 per cent, according to Vanguard’s research, while brokers will charge dealing commission.

Investors considering ETFs should also ensure they have “distributor” or “reporting” status. If they don’t, capital growth – as well as dividends – are subject to UK income tax rates.

Overseas withholding tax on the dividends of ETFs incorporated abroad can be an additional burden, while some experts are wary of ETFs structured using swap contracts because of fears of counterparty risk. Modray says: “ETFs may seem simple but they can actually be complicated vehicles.”

James Daly of TD Waterhouse, a leading broker, adds that the typical private investor remains “more confident” with unit trusts. Fewer than one in 10 clients has ETF holdings – “A lot are put off opening a relationship with investment providers they haven’t heard of,” he explains.

Many advisers continue to prefer actively managed funds. Mick Gilligan, head of fund research at Killik & Co, the broker, says that while their costs mean that active managers will on average underperform markets, “if you do your homework, you can find fund managers who can outperform.”

He says that active managers are better able to outperform in less efficient markets – for example, in smaller companies and emerging markets – though there can also be greater divergence in their results. In mature sectors such as US large-cap stocks, where an active manager will struggle to add value, he favours a tracker.

With some discount services, investors can also bring down the costs of actively managed unit trusts and Oeics to fee levels close to those of trackers or ETFs. For example, Alliance Trust – which has 50,000 investors across its dealing, Isa and Sipp platforms – rebates all the annual commission it is paid by fund providers, typically equivalent to half the quoted management fee, and charges a dealing commission of £12.50 instead. This means that investors can hold a well-regarded fund such as Aberdeen Emerging Markets for an effective annual charge of just 0.75 per cent.

Investment trusts can also carry lower fees, with nearly a third charging less than 1 per cent a year including popular global funds such as Foreign & Colonial (0.68 per cent) and Bankers (0.52 per cent), according to the Association of Investment Companies.

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