The active versus passive debate has been going on for many years now, and no end is in sight. The state of the markets, whether we are in a rally or going through turbulent times, is one factor that can clearly swing the argument in favour of one side or the other. There is one consistent and prevailing argument, however, in favour of passive funds – index funds and ETFs – and that is their low expense ratios.
The flourishing of purely passive investment products over the last decade has added real pressure to the costs of the active-funds world. Asset managers have been under pressure to justify the costs charged to investors for delivering ‘alpha’– return above the benchmark index – since the last financial crisis. But what about fee pressures on passive products?
In this article we assess how cost pressures have affected the passive world and consider which of the traditional mutual fund trackers or exchange traded versions of these products – known as ETFs – are offering better value.
We have seen clear evidence of pressure on passive fund fees for both traditional index tracking mutual funds and ETFs over the last 5 years.
Using the Fitz Partners’ proprietary classifications, which amongst other factors highlight fund products that are actively enhancing an index, we are able to filter out any funds that go beyond simply replicating an index and actually offer to outperform the index. This allows us to conduct a fair comparison of truly passive mutual funds and ETFs.
When we compare the overall ongoing charges for passive index tracking products offered through clean share classes (unbundled, retrocession free retail classes) versus their exchange traded counterparts using Fitz proprietary fee calculations, we can see a decrease in the average cost of investing in the clean share classes of index tracking equity funds, and in comparable exchange traded products, from 2015 onwards. This decline is shown in the chart below.
The total operating fees of the clean classes of index funds (or index mutual funds) have reduced by 35% since 2015, from 40bps to 26bps, whilst those of ETF products have reduced by 30%, from 43bps in 2015 to 30bps in 2019.
The nature of the Index impacts product costs
It is notable that the Ongoing Charge Figure (OCF), the measure of overall fund operating costs, of an index tracking ETF product has historically been higher than that of its corresponding mutual fund clean share class. There could be a few reasons explaining the ETF’s relatively higher charges – for example, the direct extra costs of listing could be one reason for an overall higher level of fees.
In some respects, the more “complex” nature of the indices would also have a relative impact on their costs. Throughout the last few years, alongside an increase in what we would consider ‘quant funds’ (actively managed funds using systematic models in order to significantly aid stock selection) and ‘enhanced trackers’ (fund products aiming to outperform an index), we have also seen the launch of passive products tracking more elaborate indices. Although these are fully tracking an index, the index itself may be more complex than a “generic” market cap index, such as S&P 500 or FTSE100. For example, we have seen the introduction of funds tracking smart beta related indices which would attract higher charges.
Although these more elaborate indices are sometimes also offered through traditional clean classes, we find that they are more frequently available through ETFs. In the Fitz Fund Charges databases, about 20% of ETFs track indices that are not simple market-cap based indices. The difference in the nature of the index tracked by clean classes and ETF products could explain, in part, the difference in their pricing.
Review of index collection by region offers a more varied picture when it comes to fee comparison.
In order to further examine the cost differential between passive products we have filtered our data using our ‘Investment Area’ classifications and grouped indices into the four largest categories: products that focus on European, Global, US and Emerging Market indices. We have also differentiated between generic market cap and more elaborate, or “complex”, indices.
We can clearly see from the chart above that those ETFs tracking a more complex index have higher overall costs than ‘standard’ ETFs, and are, on average, more expensive than their clean counterparts.
The US sector remains an exception to this assessment. When considering funds tracking a US equity index, ETFs are always the cheapest option. The maturity of the US market and the wide offering of funds tracking US equity indices, explain why we can see an increasing number of US index tracking ETFs with very low price points.
One immediate and notable observation when we look in detail at comparable share classes in the offering of passive products is the wide range of fees that are charged for products tracking the same index. For example, considering products that simply track the MSCI Europe Index (no deviants of it such as small cap, SRI etc.) we have a range of OCFs, from 10bps to 26bps. Similarly, looking at funds tracking the S&P 500 index we see the fees ranging from as low as 5bps to over 20bps.
The vast range of exchange traded products on offer is striking when considering the offering of index tracking products in such depth. They offer a way to access a portfolio in a more fluid way than traditional mutual funds. Although there may be additional costs related to facilitating this liquidity and providing access to more complex indices, the popularity of ETFs as an investment wrapper has been demonstrated by anticipated record of global inflows in 2020*. Recently, we have even seen the introduction of ETF share classes within mutual funds, rather than as separate product ranges. These innovative mutual fund share class structures offer investors the choice of accessing the same portfolio and investment objectives through either clean or exchange traded classes.