Clearer product charges to lead to a rise in trackers and ETFs

Low-cost funds are set to soar in popularity, but cost is not the only consideration for investors. Emma Dunkley reports

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Hidden charges are the scourge of investing, but you'll be pleased to hear that imminent changes in regulation will make it easier for you to see exactly what you're paying for when buying an investment product.

And it's this realisation of what you're spending in charges, along with the rock-bottom interest rates making it hard to generate returns, that will cause low-cost tracker funds to soar in popularity.

Although it's by no means a panacea, the Retail Distribution Review – which comes into force in the new year – will make the cost of investing much more transparent, so you can see what you're paying for a product, how much in fees to your adviser and how much on other charges.

The RDR will also put an end to financial advisers collecting commission for recommending certain products, which until now, has meant some intermediaries have snatched a few per cent of your investment up-front for selling you actively managed funds.

In contrast, index-tracker funds and exchange-traded funds, which tend to be much lower in cost than actively managed funds, do not pay commission to advisers, and so have taken a back seat as a result. With the end of commission in sight, index trackers and ETFs are set to feature more prominently on advisers' radars.

"As the cost will be so much more transparent, I find investors rightly question what they receive in exchange for the cost they pay and the charge of an active fund manager is a key point of this," says Philippa Gee, of Philippa Gee Wealth Management. "So this naturally pushes investors to consider lower-cost options, which include trackers, ETFs and some investment trusts."

Index trackers are funds that aim to return the performance of the market through an index, rather than try to outperform it, like fund managers. These funds buy the shares in all the companies, or in some cases the majority of them, that make up the relevant index, such as the FTSE 100.

The benefits are that the charges are very low and you don't have the risk of an active manager who could underperform the market.

ETFs are a more recent phenomenon, emerging in the UK only 12 years ago, after booming in the United States. They are like index trackers in that they aim to follow a market, but they have the advantage of being able to be bought or sold throughout the trading day, like a share.

Whereas index trackers tend to have minimum investments of £1,000, for example, you can buy one unit in some ETFs for just over a fiver. There are also a wider range of ETFs out there, investing in Latin America equities to UK government bonds.

And there are more of these products coming to market, giving you a wider choice than before. In the past couple of weeks, Fidelity, an active fund management group, launched a US index tracker, while L&G launched the first global emerging markets government bond index tracker.

ETFs are also launching rapidly, with more refined products coming to market all the time. With such a wide choice, product providers are taking note of the need to educate independent financial advisers. "We're hiring a team to focus on the IFA market in the UK," says Joe Linhares of iShares, the largest ETF provider. "Interest in index products across Europe has really picked up over the last couple of years."

With RDR less than a month away, there has been a significant increase in the number of new ETFs listed on the London Stock Exchange in 2012 as well as new ETF providers entering the market, according to Deborah Fuhr, from the consultancy firm ETFGI. "Many providers of ETFs hope and believe that RDR will lead to increased use of ETFs by financial advisers and retail investors in the UK. In the US, the use of ETFs by fee-based financial advisers and end retail investors are a significant portion of users of ETFs."

But, as with any investment, there are risks attached to tracker funds and points you should be aware of when talking to your IFA or before buying them.

"Consumers need to be selective when they chose index trackers as there is a wide range of prices," says Peter Sleep at Seven Investment Management.

The price range of FTSE 100 trackers can go from 0.1 per cent to 1 per cent, which is quite a difference between the cheapest and most expensive tracker, says Mr Sleep.

And it's not just a one-way bet, as trackers can go down as well as up. "Trackers and ETFs will track the stock and bond market very efficiently and consumers should be aware that if the markets fall, their investments will match those falls, although over the long term they should do well," says Mr Sleep.

There are certain areas where actively managed funds, despite having higher charges, will be better value. "There's no doubt some markets are better suited to active management," says Tom Stevenson, investment director at Fidelity.

He says: "With the emerging markets, for example, there's a bigger dispersion between shares performance and it's easier for an active manager to get an edge in a less researched market."

Mr Stevenson adds that, whereas with an active fund you may, or may not, outperform the market, with an index tracker or ETF, you will simply follow it and accept that you are investing in the good companies in an index, as well as the bad.

"You can have completely passive portfolios - but just be aware that cost is not the only factor," says Ms Gee. But it is an important one.

With changes over cost transparency in view, low-cost trackers and ETFs will rise in popularity. But remember, there are still risks involved, even if they look cheap and simple.

Emma Dunkley is a reporter at Chiara Cavaglieri