ETFs – the Robin Hood of investing
On 15 November 1998 digital TV was launched.
No longer were viewers restricted to five channels – instead the same programmes can be shown on repeat across a hundred channels; I am pretty sure The Mummy II is on ITV 2 four times a week.
Alongside niche programmes and re-runs, a symptom of digital TV was the invention of shopping channels to be disseminated to a mass audience 24/7.
Once such channel was Price Drop TV. The concept of the show was a little different from the typical shopping channel and it aimed to disrupt the traditional retail model. Rather than trying to convince you that you really need a jet washer for £200, payable across twelve monthly instalments (QVC style), it used a reverse auction process.
A thousand foldable cross-trainers with an RRP of £500 would go on sale. As the virtues of a home gym were explained to you by a pair of presenters, the price of the item would slowly tick down from the recommended retail price, and viewers would call in when the item was at a price they were happy to pay.
However like any good drama, there was a twist. Rather than paying the price you called in at, you paid the price the very last buyer agreed to pay (which could have been as low as 1p!), meaning that you benefitted from someone else negotiating a better deal, even if you were happy to pay the RRP.
In 2013 the channel went bust, after many investigations from the regulators. The channel had covert tactics, such as exorbitant P&P fees, premium phone lines and inflating the RRP. In essence, the business model was not viable without hidden costs.
So you ask what any of this has to do with investing, and in particular ETFs?
When it comes to fund management charges a remarkable number of parallels can be drawn.
Traditionally, investing in collective instruments has been undertaken through an open-ended fund structure. An investor decides which fund they want to ‘buy’ and subscribes into the fund.
So what fund management fee do you pay? The answer depends on how much you are investing, how you are investing (which platform or location) and who you are (retail or institutional investor).
For example, the L&G Multi-index funds have four different share classes with four different management charges. Which one you access depends where your investment comes from – an investment directly from an L&G-related company would be able to invest for 0.06% per annum, whereas a retail investor who wanted to invest a small amount of money directly with L&G may pay 0.50% a year, over 8x the price of the cheapest share class.
This is not dissimilar to the model of a traditional retailer. Nike will sell you trainers for a lower price if you are a regular wholesale buyer, purchasing bulk quantities and located in the US where Nike has its headquarters. However, if you are shopping on the UK high street, looking to buy the same pair of trainers, it wouldn’t be a surprise to pay twice the price paid by the wholesaler, even if purchased directly from a Nike store. This is not a case of Nike ripping the customer off. The sale of the trainers on the high street involves paying athletes like Mo Farah large sums of money to wear the trainers, alongside TV adverts, running a shop, paying staff and distribution and providing an after sales service. Nike may actually make a higher profit from the sale to the wholesaler.
For an open-ended fund, large investors, especially those originating from within the company or associated companies, are cheaper to service than a retail investor – still requiring regular services such as tax vouchers, newsletters and quarterly reports, no matter the value of the investment made. However, the gap between the cost to service a large institutional investor and a smaller retail investor has closed since the move towards pooled investments through platforms. This means that, rather than the fund having to deal with thousands of individual investors, much of the administrative burden passes to the platform, which in turn acts as a nominee for the retail investor.
So why have fund managers failed to cut the gap between the management charge of the highest- and lowest-priced share classes? One reason is corporate profits. If a fund has £100m in a share class with a management charge of 0.5%, cutting the fee to 0.25% is equivalent to annual revenue loss of a quarter of a million pounds. Instead, the fund is more likely to offer a different (cheaper) share class to new investors (or a rebate on the current share class), whilst generating higher revenues from its current investors. This model is very similar to utility companies, which often offer special deals to new customers, whilst existing customers end up paying a higher price.
This, in my opinion, is why the cost of investing, especially amongst active open-ended funds, has failed to fall as quickly as many expected, especially given the price squeeze for ETFs.
ETFs are a hybrid structure offering features of both closed-ended investment trusts and open-ended funds. As they trade like equities on an exchange they have to operate with a single share price, and because 80% of the trading occurs on the secondary market rather than directly with the fund manager, the ability to offer rebates to investors is extremely complex and as such, rarely used.
This means that, in general, if you are investing £1 or £100 million pounds, if you invested 10 years ago or yesterday, you will pay the same price as everyone in the ETF for fund management.
Therefore, when new entrants launch products, incumbents must make the decision to either protect revenues, or ensure their product remains competitive, especially as passive investing is often seen as a commoditised investment approach, tracking a broad market index.
At the end of 2013 the average price of an ETF tracking UK equities was 0.2%. The lowest- cost product was from Xtrackers, which had decided to disrupt the market at a price of just 0.09%.
Less than six years later, all-bar-one of the largest UK equity ETFs are priced at 0.09% or lower. When taking recent new entrants Lyxor and L&G into account, the average OCF (equivalent to the management charge of a fund) has fallen by over half.
The other ETF managers have had to react to market entrants to remain competitive, or run the risk of investors switching from one product to another.
Source: AJ Bell Investments, April 2019
This is one of the reasons why we prefer ETFs over tracker funds. Even if we do not switch products, competitive pressures mean, in the long run, you pay a fair current market price for investment management.
This brings me back to Price Drop TV.
It doesn’t matter if you were happy to be the first person to buy the cross trainer at a cost of £500, you pay the same as everyone, which is determined by what the last person was willing to pay!
Finally a word of caution. Although the headline OCF or management charge are the simplest ways of assessing the cost of investing, hidden charges and sources of revenue exist for the ETF manager, such as trading costs, taxes, stock lending revenue amongst others. In the US we have already had the first 0% ETF (charging no management fee), but as the saying goes there is no such thing as a free lunch.
A lesson from the collapse of Price Drop TV; it is important that the price you are paying is clear and transparent. As part of the investment process, a consideration of OCF or management charge is important, but the overall cost of investing should be considered. As OCFs fall towards zero for ETFs, a larger proportion of the charges for investing moves towards these harder to assess costs. MiFID II regulation aims to address this through higher cost disclosure, however harmonisation across funds still seems a long way off, making it an unfair comparison without delving into the details.
For many, passive investing means ranking index tracker funds by OCF and investing in the cheapest ones...This may ensure the headline cost at the time is competitive, but over time you are likely to pay more than you should!
That’s me for now, The Mummy II is just about to start, again!