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Cost and taxes when selecting ETFs

This article is part of
Guide to ETFs

ETFs are often lower cost than a comparable Oeic or unit trust in terms of the headline annual management fee, says Christopher Mellor, head of equity product management at Source.

However, he says the best way to compare like-with-like is to compare performance.

There are two metrics that Mr Mellor says advisers and investors should take into account when assessing passive funds: tracking difference and tracking error.

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Tracking difference is the difference between fund performance and index performance over time (usually a year). It is broadly equivalent to a “holding cost”.

Drivers of tracking difference can include headline management fees, dividend reinvestment, withholding tax rates, stock lending revenues and transaction costs.

Tracking error is a measure of the divergence between the fund and the index on a day-to-day basis. It is usually calculated as the standard deviation (or volatility) of the daily differences between the two.

A large tracking error reflects significant volatility in a fund’s performance relative to the index and a greater risk that it could underperform, Mr Mellor says.

“A fund that matches the index’s performance on a daily basis, accrues fees daily and has no other costs or expenses would have a tracking difference equal to the fees and tracking error of zero.”

When considering cost, advisers should be aware the ability to deliver baskets of securities in exchange for ETF shares eliminates the acquisition cost of the securities, says Vivian Tung, vice president for product strategy and Global ETF product at Brown Brothers Harriman.

Authorised participants pay the cost of settling the securities in the form of a creation/redemption fee, hence Ms Tung says the cost is not directly passed on to the investor.

ETFs incur very limited transfer agency costs since ETFs trade on exchange as opposed to coming through a traditional mutual funds transfer agency, Ms Tung adds. Also, she says ETFs do not generally pay selling commissions.

These structural differences result in lower costs to the manager and thus, can charge a lower TER.

Ms Tung says: “The expense ratios will impact the performance tracking of an ETF; therefore should be considered when selecting an ETF in addition to the trading commissions. The trading commissions should be considered to the overall cost of ownership for an investor.”

When choosing an ETF, Townsend Lansing, head of short/leveraged and FX platforms at ETF Securities, says it is natural to focus on the potential returns on offer.

But, whichever market you select, Mr Lansing says it is vital advisers understand the charges involved when selecting an ETF. Currently, he says advisers should be aware there is a lack of consistency in cost disclosure among European ETPs.

Mr Lansing says: “ETP issuers currently use a wide range of cost terms, such as management fee, collateral fee, custodian fee, fixed fee, hedging fee, index replication cost, insurance allowance, licence fee, stock lending return, storage costs, swap fee and total expense ratio.