Passive investment strategies and transaction costs

An investor perspective

As a retail investor, you are typically looking for low costs and reliable low risk long term returns. Your choice of funds appears to between passive trackers or actively managed funds. Leaving you then to decide on geographies or sectors. Maybe choosing something environmentally and ethically themed. This creates a nice simple decision on whether to pay for the services of honest, reliable city stock picker with a solid background in the environment and ethics or whether to follow the main market indices.

Over the last few years, the stock market has experienced a steady rise in valuations. Index trackers with low management costs being very attractive out performing many actively managed funds. On the surface the choices seams straight forward with the main debate being about index trackers or actively managed funds. A debate that can engage even the least experienced of investors.

However, the investors faces complex KIID documents and historical performance data as well as upfront investment costs, bid/ask spreads and on-going charges. We have seen lots of change in how one can access investments, the introduction of new styles of investment, and detailed regulation to guide how funds are managed and reported to investors. We have observed significant growth in passive Exchange Traded Funds (ETFs) stemming from the demand for simple and transparent products. More recently, an increase in demand for sustainable and socially responsible investment product is challenging investment managers to broaden the underlying fund objectives, and to consider factors wider than returns and risk levels only. This is the precursor to the ESG (Environmental, Social and Governance) investing principles.

Even with the moves to provide simple, well-explained investment products, we believe that investing can be complex and at times counterintuitive. This article focuses on an area, which can be confusing: the costs and charges. We look at typical investment vehicles used for passive investing, explain how costs and charges may differ, and what to expect from investor reporting set out in the regulations. We explain some of the detail in pricing methodologies in an effort to highlight counterintuitive dynamics.  Lastly, we review how we could expect different investment strategies to have an impact on the types of cost and charges. In what appears to be a disparate set of topics, the reader will see that these concepts are interrelated and important to understand in making choice between investment funds.

 Simply implemented with a simple set of rules 

The passive movement was started by the CEO of Vanguard in 1975, John C. Bogle.  The new approach essentially simplified investing, allowing an investor self-directed entry to market. Under this straightforward approach to investing, an investment manager sets up the ETF, purchases the physical stocks for the ETF, and thereafter any retail investor can gain access by purchasing shares of the ETF on the exchange via a stock broker. The main benefit is that ETF’s are priced throughout the day and visible on exchange bulletins. From an investment strategy perspective, ETF’s often utilise a passive investment strategy, which is relatively easy to set up, and requires minimal resources to maintain. In its raw form, passive investing can be achieve by following, or tracking, the proportions of stocks in a market-based index, such as S&P500. Fortunately, there is a well-supported argument for using what feels like a naïve investment strategy.  Index performance is not easy to beat (a fair proportion of funds do not achieve the returns overtime that the index can). From an investment returns perspective, for an investor choosing between passive funds with similar levels of risk, say between equity funds, costs and charges becomes very important.

Does the investment vehicle matter? 

Behind the scenes, purchasing of an ETF is different from that of a traditional fund structure. The ETF is an entity that owns the underlying assets and divides ownership of those assets into shares listed on an exchange.  So the ETF investor is doing business, or trading, directly with another investor who accepts the offer price and sells. When, on the other hand, the investor is using traditional fund structures they are transacting with a management company that will purchase the underlying stocks into the fund at the end of the day based on the closing price of the fund. 

So popular have ETFs become that these are now the most common vehicle for passive investment rather than using a traditional fund structure. The ETF is also a favoured vehicle for robo-advisors as the order is placed with ease via an exchange, allowing for a greater degree of automation. Role-players such as wealth managers and brokers have now invested heavily in providing online technology and phone apps allowing investors to invest directly in the ETF with the click of a button (or tapping of a screen).

ETF’s and traditional fund structures do adhere to the same regulations and how they are reported, however there are specific differences between these two main passive strategy investment vehicles:

* Traditional fund structures such as unit trusts and open-ended investment companies (OEICs)

Does a more active investment strategy matter?  

There has been a recent surge in ETF’s which are not pure index tracking, or are based on an index with specific weightings towards factors (such as Momentum, Low Volatility and Quality) implemented into products known as Smart Beta. These products capture the benefits of index tracking in that the products are relatively simple to implement and use transparent trading rules.

Each investment strategy offers the potential for added returns by comparison to the humble passive investment strategy, but this will have associated risks and most likely an added cost. The investor will ultimately need to weigh up whether the potential additional reward(s) outweigh the added risk and costs associated with diverging from a purely passive investment strategy. A way to think of it is that for a similar risk level, the additional returns needs to cover the additional costs that will come with a particular investment strategy.

ESG strategies consider risks and cost in broader societal terms. ESG investment strategies are not immune to increases in risk and costs. Again, the comparison of risk and costs relative to the pure index-tracking portfolio would be a good departure point when weighing up the broader benefits.

Costs and charges - Enter regulations: PRIIPs and MIFID II 

It is well known that costs and charges directly affect investment returns and at times significantly. It is important for an investor to understand how these costs and charges affect the return of the particular product and be able to compare to peers in a transparent way. At this point, we introduce the regulatory frameworks to do with costs and charges below.

Fund factsheets have traditionally reported costs and charges, but regulations have been introduced recently that provide lots more detail on how to calculate costs and charges, with specific reporting templates for investors:

• Packaged Retail and Insurance-based Investment (PRIIPS) rules came into force in January 2018 and apply to a wide range of retail investor products. PRIIPs rules detail specific methods for product disclosure, risk classifications, and reporting formats for cost and charges. 
• Markets in Financial Instruments Directive (MIFID II) also came into force in January 2018.  MiFID II requires distributors to provide costs and charges information to investors both pre-sale (ex-ante) and post-sale (ex-post). MIFID II and PRIIPs have also now specified the disclosure of costs and charges on the Key Information Document (KIDs).
• Cost transparency initiative (CTI) – not a regulation, but it is an industry led reporting requirement for asset managers to report charges to the trustees of workplace pensions. This enhances transparency to pensioners and assists in establishing value for money.

The regulations are slightly different, but the aim is the same; investor protection by providing comparable, comprehensive and meaningful disclosure. On the surface, investors would prefer to select a fund with the lowest costs but there are a few considerations to bear in mind, so first lets breakdown costs at a high level.

 Summary level breakdown of costs and charges:

• Upfront, one off, charges: this includes upfront fees, distribution (sales) fees, initial charges, and exit fees for redemption
• Transactions costs
• Explicit costs: includes broker commissions, transaction taxes, etc
• Implicit costs: hard to quantify and not directly observable. This includes costs of bid-offer spread, arrive price, market impact and delay costs. Priips requires the difference between mid-market price at the time of the order and the price when the deal is struck as the as the implicit costs. This can vary according to market liquidity and volatility at the time.
• On-going costs: management fees, admin, operational costs, fund-of-fund costs, stock lending and research fees. Lastly performance fees (in the case of meeting alpha performance targets, not an issue in passive investing).

In general, the prescribed methods for cost and charges can be different between the regulations making a like-for-like comparison difficult to observe directly. PRIIPs is set up for pre-sale only and reports ex-ante (or expected costs) whereas MIFID II reports differently. The MIFID II rules have two levels of cost disclosures:  one for informing potential investors with ex-ante costs and another to report to existing investors with ex-post (actual) costs over the prior year. 

When it comes to ongoing charges, passively managed ETFs do tend to be cheaper. A passively managed ETF will almost certainly have a lower expense ratio than an actively managed traditional fund. Keep in mind a passive traditional fund structure may also be a very inexpensive way to invest. 

If we review the costs of an investment vehicle, there is one important factor that one would expect to increase when moving from a passive strategy to active in the same investment vehicle:  fund turnover. This literally means the proportion of the fund that needs to be bought and sold in order to extract the benefit from the active strategy. For every purchase/sale, there is an associated cost of performing the transaction, so it would be natural to expect that constantly-traded portfolio’s and strategic rebalancing are more costly than a buy and hold strategy. 

As the illustration shows, the different factor strategies have varying levels of trading activity and costs to maintain the tilts. As we have previously highlighted, ETF’s are cheaper with very low headline charges; but costs of trading may eventually outweigh this benefit. Certain factor strategies will require more trading (such as a momentum strategy). A cursory glance at costs and charges when investing may not indicate a costly product, but fund turnover costs can be the most expensive part of an ETF fund, so important to look out for it.

The PRIIPs regulation is a real benefit to investors seeking to make fund choices, with consistently presented information on costs and charges. Whereas the transaction costs have not traditionally been reported on fund factsheet and KIIDs documents, this will be reported and make the comparison between ETF strategies more accessible.  We therefore feel that investors would benefit in the end by the regulation, albeit not fully implemented at this stage.

Conclusion: It’s a multifaceted problem 

Investments are not equal for many reasons; shopping for an investment requires assessing many factors concurrently. We know now that there are merits to the investment vehicles and we have highlighted that ETF strategies are not solely passive. As we have shown, costs and charges can be complex and reporting of these is seemingly difficult to compare. They are however important to review and investor reporting outputs, like the PRIIPs KID, is a good source of this information.