Secrets Of Success: UK index funds finally reach maturity

Fidelity's decision to slash the cost of its core UK tracker fund surely marks the point that the market for index funds in this country has finally reached maturity. The reality, in today's high-technology world, is that tracker funds, as low-cost computerised products that mechanically follow a given market index, should be a commodity and priced accordingly.

The barriers to entry are low, meaning every fund group can provide them with ease, and, in theory at least, all tracker funds for a given index should behave in the same way. Apart from cost, in the main they do. (There is diversity in the way that different index funds are managed, and some providers have better techniques for doing so than others - which produces differences in so-called "tracking error" - but they are rarely that divergent as to be a material factor for those buying them.)

But it's taken a long time for the market to work as efficiently as it should. In the institutional market, index funds have been commoditised for years. Some institutional buyers pay virtually nothing for a core index fund. But in the retail market, the one inhabited by ordinary investors, it has taken an age for prices to come down to sensible levels.

When the index fund movement first started in the UK, with Virgin Money and Legal & General well to the fore, they were promoted as being cheap alternatives to actively managed funds, even though their annual management charges - at 1 per cent per annum - were way above the levels seen in the US, where index funds have been around much longer.

Now, as the table shows, the cost of buying an ordinary index fund over here has started to come down significantly. Fidelity's new offer is a UK equity index fund, which carries an annual management fee of just 0.1 per cent and an expense ratio of 0.3 per cent - the latter is the figure that really matters to investors, as it represents the real bite that the fund provider's charges will take out of investors' money each year.

The figures in the table are taken from the Financial Services Authority's (FSA) comparative costs tables (accessible via its website, www.fsa.gov.uk) and show the total amount that investors who buy an index fund can expect to pay over periods of five years, assuming an initial investment of £7,000 (the maximum ISA allowance) and a standard growth rate of 7 per cent per annum. The figures show there is still a huge gap between the cheapest and most expensive providers.

For example, in the FSA table, the cheapest provider remains Foreign & Colonial, followed by four other firms whose charges will amount to less than £300 for a five-year holding period, while the most expensive comes in at more than three times as much. When looking at these figures you need to be careful in how you interpret them.

In many cases, it is possible to reduce the cost of an index fund by buying directly or through a discount broker and avoiding the initial sales charge altogether. The figures Fidelity gives in its key features document show the cost of its fund as less than £100 over five years. It does not impose an initial charge of any kind on the funds in its MoneyBuilder range, regardless of how you buy them (directly, online or through an intermediary).

It is worth repeating that, unless an index fund shows a wide tracking error, there is no point in buying an index fund that is more expensive than the cheapest you can find. Brand names, by and large, should count for nothing in the index fund business, although there is something to be said for a provider that has a good back office, doesn't lose your certificates, has a helpline that connects you quickly to a person.

The downside to paying more than you should is that the costs of index funds, like the costs of all funds, compound over time. What looks like a small difference in cost this year - say the difference between paying 0.3 per cent and 0.7 per cent a year - can turn out to be very large indeed over the life of your investment. I have included the costs in my table of making regular monthly payments totalling £7,000 a year into an index fund for a period of 25 years, which illustrates how dramatic this effect can be.

Assuming the same growth rate of 7 per cent per annum, you can see that the difference between the cheapest and most expensive fund is potentially £75,000, with the cheapest fund costing you £30,000 and the most expensive £105,000. That works out at an extra £3,000 a year in cost during the life of the investment. It is hard to believe that any rational investor would voluntarily agree to pay that much if they knew how much they were being charged.

So the message, as with all commodity products, is: shop around. If you have some index funds, then it will be worth looking to transfer to cheaper alternatives, especially as many providers will bribe you to switch to their product. If you are about to put some money into a tracker fund for any reason this year, then make sure you buy the cheapest one from a proven provider that they can find.

And finally, if it turns out that your adviser has left you sitting in an expensive index fund for some time now, ask him how they can justify not getting the best value they can for you. Most advisers these days should be able to negotiate a hefty discount on your behalf, but there is no reason why you cannot do that part of the job yourself. It is a straightforward, common sense thing to do: or as Jason Zweig, one of the best American columnists likes to say: "If we bought stocks the same way we buy socks, we would all be a lot better off." This is true, regardless of whether you have all your money in index funds, or simply a proportion, with the balance in actively managed funds, where the costs over 25 years are also worth taking a look at on the FSA website, as some of them will make your eyes water.

jd@intelligent-investor.co.uk