ETFs: A Cheaper Way For Pensions to Go Passive?

20867_canadian_money_1Here in Canada, explaining the benefits of ETFs starts with a simple proposition: they’re cheap. Compared to mutual funds with MERs in the range of 2 to 2.5%, ETFs with MERs of under 0.5% take a substantially smaller bite out of an investor’s savings.

Not so for institutional investors, for whom ETFs are more expensive than other passive index mutual funds. But last week, I found this article in that compares ETF fees to the actual benefits the investment brings to a portfolio especially compared to index funds. It’s an interesting breakdown of ETF fees and benefits, even though the example is UK-based.

According to the article, UK pensions say fees are the biggest barrier to entry in the ETF market. Citing figures from Towers Watson, the article notes that the cost for an institutional investor of a typical passive global equity portfolio of over £50 million in size would be between 10 to 15 basis points (bp) a year. Meanwhile, comparable ETFs charge 25 to 50 bp.

Despite the fees, however, ETFs are a more cost effective way for a pension fund to take a passive stance, especially with tracking error is taken into account. In this case, the true cost of ETFs compared to index funds is signficiantly decreased or eliminated. For example, notes the article:

“If the FTSE 100 index rose 10% over a year, an index-tracking fund with a 10 bp cost should rise 9.9%. However, says, “In many cases index funds only rise 9.8% due to undisclosed stamp duty or dealing costs,” notes Aldous. “An ETF can go up by 9.9% or 10%, though. On the basis of tracking difference against the index, ETFs are generally as cheap or cheaper by a couple of basis points, as well as offering the additional benefit of liquidity.”

In short, while ETF fees might look higher, a better way to look at it is their net performance against the index, in addition to the costs of buying and selling them. Providers also continue to argue that ETFs are more liquid and offer a better way for pension funds to transition smoothly in and out of new asset classes.

I wasn’t able to find similar data for Canadian pension funds but it would be interesting to see a study in how pension investors here in Canada view the costs of ETFs versus the benefits. As always, comments are welcome below – are you using ETFs and if so, why?

Originally published in Benefits Canada.