What are your ETFs really costing you?

Europe's exchange-traded fund (ETF) market is growing healthily as more investors switch to passive' index-tracking from pricier actively managed funds.

But when you're comparing the costs of a tracker with an active alternative, remember the ETF doesn't give the exact index return. It incurs management fees and other costs just like an active fund, leading it to underperform slightly. For a full picture, you have to compare the after-cost return on the ETF with that on a rival product.

By law, any European mutual fund must reveal a measure of recurring annual costs, its ongoing charges', in its Key Investor Information Document (found on the issuer's website).

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The ongoing charges figure has replaced a previous measure of cost, the inaccurately named total expense ratio' (TER). One big problem with the TER was that it wasn't total.

However, unfortunately, the new ongoing charges' measure also might not give the full cost picture, particularly in funds investing internationally or in less liquid underlying asset classes.

Here's an example from the ETF market. The three largest broad emerging markets equity ETFs in Europe are iShares' IEEM (charging 0.75%), db x-trackers' XMEM (0.65%) and Lyxor's LEM (0.57%). All three track the MSCI Emerging Markets index.

However, looking at their 2013 performance, IEEM lagged this index by 1.37% (see chart), XMEM by 0.98% and LEM by 0.77%. In IEEM's case, that's almost double the underperformance you'd expect if looking at ongoing charges only. But all the funds underperformed the index by more than their headline fees.

Why? The ETFs' managers incurred costs when buying and holding the shares in the 21 emerging markets constituting the index. These costs are passed on to investors.

In db x-trackers' case, the extra costs are recorded on the website as "swap transaction costs" of 0.3% a year. But such frictional costs are not recorded in the ongoing charges figure, which aims to measure only predictable recurring fees.

There's no guarantee that an active fund investing in emerging markets will do any better. But when comparing costs, remember to use the historical returns on the ETF, rather than the return on the index, as a guide.

And don't forget to include entry and exit costs, such as your broker's commission fees, the bid-offer spread (the gap between the buying and selling price) and platform costs for holding funds.

Paul Amery (Paulamery.net), ex-fund manager, is now a freelance journalist.