Take control
As an investor, you could not have done anything to prevent the late '90s tech bubble or the collapse of Lehman Brothers. The resulting declines and subsequent rebounds in global financial markets were similarly beyond your control (although you could have taken an antacid to mitigate the effects on your stomach). And while you won't be able to shape future events that move financial markets, nor the markets themselves, you can control the price that you pay to participate in those markets. In fact, minimising costs has proven one of the most effective ways to consistently outperform the average fund over an extended time horizon. And the best part is that your investment costs are more within your control than any other aspect of investing.
Investment management costs defy conventional economic logic. A more expensive fund isn't likely to outperform a less expensive one the way you would expect a Ferrari to outstrip a Peugeot. When confronted with two investment options--one sporting an annual expense ratio of 1.5% and the other 0.25%--the only guarantee is that you will pay an additional 1.25 percentage points to invest in the former. Virtually every study we have seen of funds has shown that funds charging higher fees tend to underperform those with lower fees. In fact, the fund's expense ratio is the single greatest predictor of fund performance--greater than past performance, and even greater than our star rating (though using low fees with our star rating proves a powerful combination). Whether investing in equities or fixed income, large capitalisation companies or small, and regardless of geography, the lowest cost funds have consistently outperformed their more expensive peers.
ETFs are low-cost leaders
One of the most appealing features of exchange-traded funds (ETFs) is their low costs. The average total expense ratio (TER) for European equity ETFs is 0.37%, less than half the annual cost of the average equity index fund (0.87%) and about one-fifth of the cost of the average actively-managed equity fund (1.75%). While these cost differentials are substantial at first blush, they become even greater as they compound over time. Let's use these three averages to show the benefits from minimising costs over an extended time horizon.
Assume that we put £10,000 into three separate investment vehicles: an ETF that charges the average total expense ratio of 0.37%, an index fund with the average expense ratio of 0.87%, and an actively managed fund charging the average expense ratio of 1.75%. For simplicity's sake, let's ignore transaction costs (commissions, sales charges, etc.) and taxes for the time being and assume that each portfolio produces an identical 8% annual return before expenses over the next ten years. At the end of a decade, the ETF portfolio's value will have grown to £20,861, while the value of the index-tracking fund portfolio will be 4.5% less at £19,912, and the actively managed fund portfolio--at £18,335--will be worth 12% less than the ETF.
This divergence in returns owing to cost differences will only grow even larger over time. At the end of 30 years with the same return and cost assumptions, the total value of the ETF, index-tracking fund, and actively managed fund will be £90,782, £78,947, and £61,641, respectively! Over the course of three decades, the higher cost, actively managed fund is worth a whopping 32% less than the low-cost ETF portfolio, despite posting identical pre-expense returns.
It is plain to see that keeping costs in check can go a long way in improving one's returns. Considering that most active managers tend to underperform their relevant benchmarks over time, replicating an index return with a low-cost ETF investment is all the more appealing for long-term investors.
What are my options?
There are currently over 1,000 ETFs to choose from. So with low costs as the primary criterion for whittling down our options, let's take a closer look at what's out there for investors searching for broad equity exposure. Here's a look at a few of the lowest cost options on the equity ETF menu.
db x-trackers DJ Euro STOXX 50 ETF: With a total expense ratio of 0%, the db x-trackers DJ Euro STOXX 50 ETF is as low as management costs can go. This broad barometer of the European equity markets uses swap contracts from Deutsche Bank to match the return of the DJ Euro STOXX 50 index, which gives Deutsche Bank's trading desks more flexibility to make income from the fund holdings and split the benefits with ETF shareholders. The use of swap contracts exposes fund shareholders to the risk that Deutsche Bank might not be able to deliver the index returns it promised, though the fund usually holds even more than its value in collateral to guard against precisely such a situation. But we don't want to get too far into the weeds here, as swap-based ETFs are an important topic that will have plenty of their own articles in the future.
As for the index itself, at a 31% allocation, it is heavily weighted towards financial companies, with Banco Santander, BNP Paribas, and BBVA amongst its 10 largest constituents. This fund is listed on the Mercado Continuo Italia, Euronext Paris, Swiss Exchange, London Stock Exchange SETS, and Deutsche Börse.
iShares FTSE 100: The iShares FTSE 100 ETF does not boast the lowest management cost amongst funds replicating this broad UK equity benchmark (its current TER is 0.40%, while a number of competitive offerings have a TER of 0.30%). However, it is the largest and the most frequently traded of the bunch. The benefits accruing to a larger, more liquid fund typically include lower hidden trading costs that can be more important than small differences in TERs (we'll have more to say on trading costs in a coming article). The FTSE is heavy on financials and resources. Shares of financial, basic materials and oil and gas firms comprise nearly 56% of the index. The fund is listed on the London Stock Exchange, Borsa Italiana, NYSE Euronext Amsterdam, and Chi-X.
iShares AEX: The iShares AEX ETF has a TER of 0.30%--on par with its competitors. However, as is the case with the iShares FTSE 100 ETF, the iShares AEX ETF is far larger and more heavily traded than the competition. The AEX has a good-sized slug of consumer goods exposure (about a 25% allocation), owed largely to the fact that Unilever has around a 14% weighting in the index. Basic materials stocks are the next-largest component at about 19%, thanks mostly to an approximate 13% stake in Arcelor Mittal. The fund is listed on NYSE Euronext Amsterdam, The London Stock Exchange, and Chi-X.
