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Low costs have helped to make passive investments popular

Cost-conscious investors have been ploughing billions of pounds into exchange-traded funds (ETFs) over recent years, while many actively-managed funds have suffered significant outflows.

Improving transparency within the funds industry has made it easier to compare the costs of various investments, so it’s no real surprise that the popularity of low-cost ETFs has soared.

Research from financial services group State Street shows that investors poured an incredible $464bn (£353bn) into ETFs in 2017 alone.

Meanwhile, figures from life insurer Royal London show that passive investing – a term used to describe tracking an index rather than actively picking certain stocks or bonds – now accounts for nearly half of all assets under management. That compares to just 15 years ago when they accounted for a ‘negligible proportion’.

WHY ARE ETFS POPULAR?

As well as their low costs, and the ease and speed of buying and selling an ETF, a major part of the reason for the growing popularity of trackers is that they’ve performed particularly well as global stock markets have soared in recent years.

Unsurprisingly, that has caused many investors to question whether it’s worth paying more for an active fund manager.

And as more money has flowed into ETFs, they have been able to pass on the economies of scale, reducing their costs further and further. Earlier this year, for example, BlackRock slashed fees on 11 of its tracker funds. Meanwhile in the US, investment giant Fidelity created waves when it launched a zero-fee tracker.

While charges haven’t come down quite that far yet in the UK, they are well on their way. Number-crunching from investment platform provider AJ Bell shows there are 36 UK-listed trackers with fees of just 0.07% or less.

The cheapest three ETFs charge investors just 0.04%; that’s just 40p for every £1,000 invested, and is a fraction of the average active fund charge, which currently stands at around 1%.

The cheapest offerings are simple trackers which mirror a well-known stock market, such as the FTSE 100 or S&P 500.

Other ETFs which feature in the list of cheapest trackers include those which follow the Euro Stoxx 50 index of European blue-chip companies as well as those which track US Treasuries (also known as US government bonds). These funds tend to be cheaper because the indices they track are easy to set up and monitor, and the trading costs in these markets are relatively low.

HOW ARE ETFS ABLE TO KEEP THEIR COSTS SO LOW?

ETFs can be cheap because they don’t have the same running costs as an actively-managed fund. ‘It’s slightly tongue in cheek to say that tracker funds can be so cheap because you don’t have to pay an expensive fund manager to run them, but it is also quite true. Trackers are essentially run by computer programmes, which are highly scalable,’ says Ben Yearsley, director at Shore Financial Planning.

The hefty flows of money into these products has massively ramped up competition, which has put pressure on prices. Providers have been caught up in a price war in order to attract investors as a seemingly never-ending stream of new ETFs is launched.

While an active fund might be able to hold its price because it has a particularly well-known or skilful manager at the helm or expertise in a certain region, there is little to differentiate one FTSE 100 tracker from another.

The size of a fund and its tracking error are factors to consider, yet in the end, for many investors the final decision on which ETF to pick will often come down to cost.

Adam Laird, head of ETF strategy at Lyxor, adds: ‘Technology has been a major factor in the collapse of fees in the ETF space. At one time, you would have needed to dedicated fund managers to keep a ledger of holdings, to process trades and monitor the index. Now a small team can look after dozens of funds.’

WILL COSTS COME DOWN EVEN FURTHER?

While the price war has been forcing costs lower over recent years, few commentators think that a 0% tracker is likely to hit the UK market any time soon.

Aside from some complex trading features of these funds and regulation, the model only tends to work for firms which
can offset their costs in other areas of the business, through their fees on active funds or advice, for example.

Antoine Lesne, head of ETF research and strategy at State Street, explains: ‘The “bait” of a zero-fee product could be an incentive for an investor to open an account, which then gives the provider a chance to up-sell various products and services.’ (HB)

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