Fidelity: More to index funds than low fees

For every complex problem there is an answer that is simple, clear and often wrong. So it is with index funds and fees. Investors may be drawn to funds with the cheapest OCF, believing their interests are best served by having the lowest fees possible. After all, for funds that track the same index, how much impact can other factors have? The answer, it turns out, is quite a lot.

Logically, good client outcomes for index tracking funds should be judged less by OCF than by tracking difference - a measure of how closely a fund tracks its index - as it gives a truer reflection of the ‘cost’ of ownership. However, comparing tracking difference between funds is complicated.

Below we outline four factors that distort the comparability of tracking difference: valuation point, dilution policy, fair value policy and withholding tax treatment. Investors need to be aware of these so they can conduct the right kind of due diligence in order to achieve better investment outcomes.

In the UK, most index funds are valued at midday due to historical convention, whereas the indices they track are priced at market close. This can cause the tracking difference of a fund to appear greater than it actually is, which can have a pronounced effect either in favour of a fund or against it.

However, this distortion does not reflect a real loss of money or poor manager skill, it is merely a statistical glitch. Investors should check for mismatches between the valuation points of a fund and the index, and, if necessary, contact fund providers who should be able to evidence how closely funds are really tracking.

In addition to the valuation mismatch, further problems arise in the performance reporting provided by data vendors if the fund uses a custom index that the data vendor does not have access to. As such, any quantitative fund ratings provided by data vendors may not give an accurate reflection of the quality of a fund.

Fund costs can erode returns over the long-term so it’s important to understand precisely what you are being charged for and how. Each time an investor enters or exits a fund it creates cashflows, requiring the manager to buy or sell securities as needed. Trading securities incurs transactions costs in the form of brokerage commission, taxes and stamp duty, and bid-ask spreads. Despite contributing to the overall cost of ownership and diluting returns, they are not included in a fund’s OCF. But the effect of transactions costs should not be underestimated - they can amount to more than the OCF.

Fund providers use different measures to combat dilution costs. Examples include an anti-dilution levy, dual pricing and full or partial swing pricing. Managers are free to approach dilution costs in the way they feel best serves the interests of their investors. Each has pros and cons and there is no obviously superior method.

One fund we analysed that uses full swing pricing coincidentally valued at the offer price at every month-end in our sample period, helpfully providing a consistent pricing basis at exactly the point at which statistical tracking errors are typically calculated. What is clear is that potential dilution costs are not transparently disclosed in fund Key Investor Information Documents. The different ways in which funds handle these costs can make standard tracking difference/error difficult to compare across products. This is something investors need to consider as they make fund selections.

Fair value policy ensures that when funds are valued, the price used to value the underlying assets is fair, thereby protecting ongoing, incoming and outgoing investors. Events around the globe can impact the price of securities in a fund even when that market is closed. When funds calculate the price at which investors can deal, the previous market closing price might not be an appropriate reflection of the fund’s true value, and if the price is not adjusted, investors buying or selling units might make a gain at ongoing investors’ expense.

Funds that fail to use fair value pricing create opportunities for short-term market timers, who exploit any mismatches at the expense of long-term investors in the fund. Our research shows that two European-domiciled index funds that both track the S&P 500, are priced at midday and have the same OCF, can differ in daily returns by as much as 5%.

Investors should look for funds that use a fair value pricing policy to avoid such situations. This involves adjusting a fund’s price to reflect events that occur after the market closes, ensuring all investors in the fund are treated fairly.

How a fund handles withholding tax - the tax paid on equity dividends - can also have a significant impact on performance. A fund’s domicile and legal structure will determine its withholding tax treatment, and this can vary depending on where the dividends are being paid from. For example, a US equity fund domiciled in the UK pays 15% on the dividends it receives, whereas a fund tracking the same index domiciled in Ireland or Luxemburg will pay withholding tax at 30%. Given that the S&P 500’s historic gross dividend yield is around 2%, this can amount to a difference in return of around 30 basis points a year, far more than the typical OCF for an S&P 500 index fund. Moreover, some funds may gain a tracking difference advantage by measuring themselves against an index with less preferential tax treatment. To continue the example above, the official S&P 500 net (of withholding taxes) total return index assumes a tax rate on dividends of 30% cent. This means that a UK-domiciled fund, taxed at only 15% would incorrectly appear to have a cumulative 3.4% better tracking difference over the past five years using this index.

S&P does produce a custom index especially for funds domiciled in the UK that taxes dividends at 15%, but data vendors often do not have access to such indices -another reason why it pays to be careful when using third-party quantitative fund ratings. It is vital to analyse each fund and index for any mismatch between the treatment of withholding tax as this will lead to distortions of tracking difference.

Unfortunately, there is no simple way for investors to be sure of the true cost of owning an index fund. It is understandable that investors gravitate towards a lower OCF but this does not give a full picture of the total cost of ownership. Tracking difference should potentially be a better guide, but a thorough analysis of the four factors above should be carried out when comparing funds. As with active funds, due diligence is just as important when choosing index funds. Asking the right questions can lead to better investment outcomes.

 

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Important information

This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from can go down as well as up and investors may not get back the amount invested. Investments in small and emerging markets can also be more volatile than other more developed markets. Changes in currency exchange rates may affect the value of an investment in overseas markets. Issued by Financial Administration Services Limited and FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbols are trademarks of FIL Limited.