Passive funds have been with us for some time and they are now very much a mainstay of many an adviser’s investment proposition. They have numerous applications, ranging from short-term trading positions to long-term core holdings.
Whatever their use, one thing has become clear: demand for passive funds is increasing and is likely to continue to do so. Fund providers clearly recognise this trend and they have responded accordingly.
There used to be a handful of passive funds to choose from whereas now there are hundreds. Not all of them are quite what they seem. There are index-tracking unit trusts and exchange-traded products with various fee structures. Some hold all the constituents of the index that they track, others hold assets that are nothing to do with the index or commodity that they are tracking and are reliant on a derivative contract for their return but all share the same characteristic in that they offer low-cost access to a specific asset or sub-asset class.
With all these new found layers of complexity, what is the easiest way for one provider to differentiate their funds from the competition and so gain market share? The simplest solution is to compete on price, which is precisely what has been happening in the past year or so. We have seen new lower-cost entrants to the market, such as Vanguard with costs starting at less than 10 basis points. To combat this existing providers such as L&G and HSBC have cut costs on their existing fund ranges. This is fantastic news for investors as it is now possible to create a fully-diversified, balanced portfolio for a cost of less than 30bps for the underlying funds. (Unfortunately the costs of the platform could easily add an additional 30bps to the cost. There is certainly potential for a squeeze on wrap costs and I am sure we will see this before too long.)
While we are clearly witnessing a price war in the passive sector, how much lower will prices go and will all competitors react accordingly?
The largest player in the passive marketplace is iShares with more than £100bn in ETPs in Europe. Following the cost-cutting seen elsewhere from both exchange-traded funds and tracker fund providers, iShares has now begun to join in although fees on some of its most notable funds remain unchanged. Why is this? To understand it is important to remember that institutional investors are currently the main buyers of ETFs.
I recently attended the launch of an ETF aimed at institutional investors. By contrast to the IFA space, I was struck by the lack of audience interest in the fees quoted for the new funds. What gained a lot of interest were three things: details on the underlying index to be tracked, estimates of tracking risk and, most important of all, liquidity and trading costs. Institutional Investors are different animals to financial advisers. There were no questions about the headline total expense ratios but many questions about how cheaply the stock could be traded.
