Passive funds have been with us for some time and they are now very much a mainstay of many an adviser’s investment proposition. They have numerous applications, ranging from short-term trading positions to long-term core holdings.
Whatever their use, one thing has become clear: demand for passive funds is increasing and is likely to continue to do so. Fund providers clearly recognise this trend and they have responded accordingly.
There used to be a handful of passive funds to choose from whereas now there are hundreds. Not all of them are quite what they seem. There are index-tracking unit trusts and exchange-traded products with various fee structures. Some hold all the constituents of the index that they track, others hold assets that are nothing to do with the index or commodity that they are tracking and are reliant on a derivative contract for their return but all share the same characteristic in that they offer low-cost access to a specific asset or sub-asset class.
With all these new found layers of complexity, what is the easiest way for one provider to differentiate their funds from the competition and so gain market share? The simplest solution is to compete on price, which is precisely what has been happening in the past year or so. We have seen new lower-cost entrants to the market, such as Vanguard with costs starting at less than 10 basis points. To combat this existing providers such as L&G and HSBC have cut costs on their existing fund ranges. This is fantastic news for investors as it is now possible to create a fully-diversified, balanced portfolio for a cost of less than 30bps for the underlying funds. (Unfortunately the costs of the platform could easily add an additional 30bps to the cost. There is certainly potential for a squeeze on wrap costs and I am sure we will see this before too long.)
While we are clearly witnessing a price war in the passive sector, how much lower will prices go and will all competitors react accordingly?
The largest player in the passive marketplace is iShares with more than £100bn in ETPs in Europe. Following the cost-cutting seen elsewhere from both exchange-traded funds and tracker fund providers, iShares has now begun to join in although fees on some of its most notable funds remain unchanged. Why is this? To understand it is important to remember that institutional investors are currently the main buyers of ETFs.
I recently attended the launch of an ETF aimed at institutional investors. By contrast to the IFA space, I was struck by the lack of audience interest in the fees quoted for the new funds. What gained a lot of interest were three things: details on the underlying index to be tracked, estimates of tracking risk and, most important of all, liquidity and trading costs. Institutional Investors are different animals to financial advisers. There were no questions about the headline total expense ratios but many questions about how cheaply the stock could be traded.
Similarly no one asked for performance comparisons with rival funds but there was a great deal of interest in the volatility and correlation characteristics of the underlying indexes. The assumption that the fund would closely mirror the index was implicit. They simply view tracker funds as a commodity to populate an investment strategy that can be traded for minimal cost in differing market conditions. As such they view the total cost of ownership to be all important.
Thinking back to iShares, this helps to explain why not all its funds have had charges reduced in reaction to competition. For example, its S&P 500 income fund has a TER of 40bps, yet has produced a return within 0.06 per cent a year of the underlying index since launch.
For the majority of its target market (institutional investors), this fund produces exactly what is required. For the remaining minority, (retail clients and their advisers) the view is partially obscured by the fact that the fund looks quite expensive relative to alternative funds. It is inconvenient to have to say to a client that you are recommending a fund that is more expensive than some other choices but that it may well produce better net performance. This is both confusing and counterintuitive for the poor retail client and his adviser.
To address this point, the iShares S&P 500 Accumulation Fund has recently cut costs to 15bps. This fund is designed to appeal to the longer-term retail investor who will be rewarded in cost for a buy-and-hold strategy. However the income fund is likely to remain more liquid than the accumulation fund and so will still remain popular with institutional and active investors.
The chart shows two FTSE 100 Trackers: an ETF from Vanguard costing 10bps and a tracker fund from HSBC costing 17bps. From a performance point of view, which fund would be most suitable? Unsurprisingly the chart suggests the Vanguard fund is the top performer.
However this chart is on a bid-to-bid basis, taking no account of trading spreads from the ETF. The same chart on an offer-to-bid basis shows HSBC as top performer.
Looking at this simplistically, one might opt to favour the HSBC fund over the Vanguard ETF for shorter-term holdings where dealing costs would be a more significant factor and vice versa. In practice there are many factors that could determine which would be the most suitable fund for any circumstance. Deal size, duration of holding and platform/product additional service fees and dealing costs are perhaps the most significant but not the only factors to consider from the point of view of price. There are numerous good, established tracking funds now available and a myriad of potential circumstances where each may prove to be most suitable.
A price war leading to leaner fund charges is most welcome to the retail investor. The lower costs associated with passive funds are a by-product of their precise asset-tracking approach, which in turn allows the adviser to more accurately construct and maintain portfolios with consistent risk/return characteristics.
By happy coincidence these lower costs also allow the adviser greater margin to charge fees which are appropriate for the work involved in providing a high-calibre investment service without imposing prohibitive costs on the investor.
However the servicing and dealing costs levied by platform providers have now become the more dominant element of the fee levels paid by passive investors. Further reductions by passive fund providers must be less significant in the future. Therefore should we now look to platform providers for the next significant price cut in the drive to deliver more value to the retail client?
Philip Bailey is partner of Assetfirst
Key points
Demand for passive funds is increasing and is likely to continue to do so.
The simplest solution for differentiation is to compete on price, which is precisely what has been happening in the last year or so
A price war leading to leaner fund charges is most welcome to the retail investor.
