Morningstar View: A cheaper breed of fund

Costs are the only ex-ante certainty when investing.

As such, it is easy to understand that the lower the overall cost, the higher the chances of maximising returns. During the past few years, as return expectations for most asset classes have been lowered, the issue of costs has gained prominence.

This partly explains the growing popularity of passive investment vehicles that are luring investors with the basic premise of easy access to all sorts of market exposures at a fraction of the cost of actively-managed funds.

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The theory goes that the actively managed fund industry will have little option but to also trim costs in order to remain competitive. However, many observers remain sceptical about the chances of a comprehensive lowering of fees in the mutual fund industry, citing lack of hard evidence of active funds responding to cost pressures from the likes of exchange-traded funds (ETFs).

Meanwhile, we can clearly see that the first battles of what could become a full-scale fee war have taken place among the ETF providers.

A Morningstar study cited that, on average, total expense ratios – or their new incarnation, the ongoing charge – for European-domiciled equity ETFs have steadily dropped since 2008. This is primarily as a result of new products undercutting older ones, rather than the latter cutting fees.

Although take-up has been slow, the mere existence of these cheaper ETFs has created a more competitive investor environment – where odds are building for the long-established providers to also cut their fees in order to protect their market share.

They have also prompted reaction from providers of traditional index trackers. Overall expense ratios for equity index funds have decreased on average during the past five years. This has been prominent in the UK since the arrival of ultra-low-cost providers like Vanguard.

In fact, with regulatory changes expected to generate new waves of interest in passive instruments, more providers of traditional index funds may be forced to follow in the steps of Legal & General, which cut fees on a number of core index funds in April to compete against both the ETF contingent and other traditional index trackers.

Overall, we expect the growing popularity of passive instruments, helped by regulatory changes like the RDR in other European countries, to trigger a fee war similar to the one in the US.

We expect fund providers to share economies of scale with investors, resulting in lower fees. This is standard in the US, where firms explicitly state by how much the TER will be reduced as assets grow, but it is virtually unheard of in Europe. We also anticipate more competitively driven fee reductions from providers seeking to grab investors.

Finally, we see cost pressures spreading to other areas of the value chain, with ETF and index fund issuers continuing to pursue ways to cut index licensing fees – such as changing index providers or self-indexing – and we also hope providers share those savings with investors.