A passive-aggressive approach

This article is part of
Passive Investing - October 2014

Fuelled by the financial crisis – when investors turned their backs on bank-based products – exchange-traded funds have grown rapidly in Europe and today have gathered over £350bn of assets. The flexibility, liquidity and ease of trading helped to fuel their growth. But perhaps the biggest driver has been cost.

The growth of ETFs has been accompanied by growth in index mutual funds (unit trusts and Oeics). Investors can now buy funds with annual management charges as low as 0.07 per cent a year for large equity markets, compared to the 0.75 per cent a year that they would typically pay for an actively managed fund. This may not seem much difference, but with low inflation and low returns of only 5 per cent or 6 per cent a year, this can represent a 90 per cent saving on fees and have a real effect on long-term net returns, especially as the TER does not take account of the potentially higher dealing costs within an active fund.

Table 1 shows the difference in TERs between active and passive funds for a range of sectors. Such is the pace of change that even this data from last year is likely to be out of date. The of clean share classes has seen AMCs for active funds drop to about 0.75 per cent (though TERs will typically be 0.2 per cent – 0.4 per cent a year higher), but at the same time index funds are now available with TERs well below 0.25 per cent a year for most asset classes (sometimes less than half this).

Table 1: Active and Index TERs. Source: Vanguard

Global equity1.260.21.06
UK equity0.950.580.38
European equity1.660.371.29
Eurozone equity1.430.411.02
US equity1.360.261.1
Emerging market equity1.450.371.08
Global bonds1.330.081.25
GBP diversified bonds0.73n/an/a
GBP government bonds0.270.32-0.06
EUR diversified bonds0.840.650.19
USD diversified bonds 0.930.650.28

The UK financial services regulator has also played an important role in facilitating the growth of index fund usage. The abolition of trail commission that was historically paid only by active funds has levelled the playing field. But perhaps more fundamental is the move by advisers to the use of risk-profiling tools.

Driven to have a consistent and repeatable process and by the need to show, in clear pound note terms, the value of advice, advisers are using risk-profiling tools to derive a suitable asset allocation for their customers. Once determined, advisers are then seeking to reduce the cost of the whole value chain (advice, wrapper and investment) while seeking to be appropriately rewarded for the financial planning they provide. A portfolio of index funds will be substantially lower cost than an active portfolio (with the same asset allocation) and thus help an adviser show the value of advice compared to historic products, for example, active fund of funds that typically had TERs of approximately 2.4 per cent a year.

While we are still a long way from a consistent and completely accurate price comparison mechanism (life funds often do not show TERs, and funds charges do not take account of dealing and transaction related costs) it is clear that the desire to reduce investment cost is growing.