Cheap trackers: beware hidden fees

Costs matter when it comes to investing. Small differences in annual fund expenses can lead to a big difference in the value of a fund a decade later. So it makes sense to buy cheap tracking funds whenever possible. But watch out the total expense ratio (TER) may not tell the whole story.

The TER, which all funds publish, covers the management fee and charges for services such as custody, audit and share registration. Actively managed funds often have higher TERs (1.5%-2% a year) than index-tracking funds (where it can be as low as 0.1%). But certain costs aren't included in the TER.

Money entering a fund has to be deployed. At that point the fund manager incurs dealing commissions and also the gap between buying and selling prices for the underlying securities (the bid-offer spread). Fund investors may also suffer taxes such as stamp duty on UK-listed shares. These costs affect investors, yet fall outside the TER.

The good news is that if you're investing in an index-tracking fund, these charges (which vary with the level of transactions undertaken by the fund) are likely to be much smaller than for an active fund. However, this is not always the case so it's worth checking the historic turnover figures first.

There are also some important differences between standard index funds and exchange-traded funds (ETFs), which are listed on the stock exchange. Take the Vanguard FTSE UK Equity Index fund. On the Bestinvest platform, for example, this has a TER of 0.15% and an initial charge of 0.5%. Meanwhile, the Vanguard FTSE 100 ETF has a TER of 0.1% and no initial charge.

But before you pounce on it as the cheaper option, there's the bid-to-offer spread to consider, along with the fact that it often trades at a premium approaching 0.5% of its underlying net asset value. So although there's no explicit initial charge as there is for Vanguard's index fund, you could end up paying the equivalent amount in other ways.

So in this case the main advantage of buying the standard index fund is its broader exposure (to the FTSE All-Share). With the ETF, it's the fact you can trade it at any time of day.

Given these swings and roundabouts, the type of fund you choose will depend on how often you trade, how often you save and your long-term objectives. Ideally, the platform you use should offer you access to both types of fund.

Paul Amery edits www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.