In a feature last week we covered some of the costs of investing that a fund investor should be aware of when comparing ETFs, index funds and actively managed funds.

This week we dig deeper into the subject of entry and exit fees, look at ways in which the total “costs of ownership” can be offset by other potential revenues, and touch on brokerage, fund platform and advisory costs.

Entry and Exit Costs

Investors in actively managed pooled funds (also known in the UK as unit trusts or OEICs) need to be aware of initial charges that can immediately swallow up to 6% of their capital. Exit fees may also be levied when an investment is disposed of. These charges have historically been used to remunerate intermediaries involved in the distribution of the funds.

But what about in the ETF and index fund world? Are these funds free of entry and exit charges? Not entirely, it turns out, although their charges are on a much smaller scale than those of actively managed funds.

The entry and exit charges in tracker funds relate primarily to transaction costs in the underlying markets. Understanding how these costs are levied is particularly important when seeking to make a like-for-like comparison between ETFs and index funds.

According to Dan Draper, global head of Lyxor ETFs, investors are often confused by the differences between the two types of tracker vehicle. A particularly common question is, “Why should I pay a broker’s commission and the bid-offer spread on an ETF when I can invest in an index fund at the daily net asset value?”

“You do invest at the net asset value with an index fund,” Draper agrees, “but what investors often forget is that that commissions and bid-offer spreads − and in the UK, for example, stamp duty − will have to be levied within the fund when the underlying securities are traded and will be reflected in some reduction in that net asset value. The more trading volume there is at the level of the underlying fund securities, the lower the net asset value is going to be.”

One of the economies of scale in a pooled investment fund occurs when the money arriving from new investors in the fund can be netted off against that of departing investors so that transactions at the underlying level can often be reduced. For the largest index fund operators such “internal crossing” can represent a substantial share of subscription and redemption activity. However, fund providers may also impose a so-called “dilution levy” on new investors; this is a charge which aims to ensure that the trading costs incurred when money comes into the fund are borne by the new entrants and do not disadvantage existing investors.

For example, Vanguard, the world’s leading index fund provider, levies “purchase fees” on seven of the index funds it offers to investors in the UK (and, in one case, a redemption fee as well). The purchase fees, which range from 0.1% to 1.5%, aim to cover the costs involved in buying the underlying securities in the fund, Vanguard explains, which might include local taxes or bid-offer spreads on stocks or bonds in less liquid markets.

ETFs work differently, Lyxor’s Draper says, because the costs which relate to trading in the underlying index securities are typically reflected in the bid-offer spreads that an ETF investor faces when buying or selling in the secondary market. In other words, what goes on inside an index fund typically takes place outside an ETF.

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