Investors planning to buy equity index funds need to be looking for more than just the trackers with the lowest ongoing charges if they hope to achieve the best results, according to Fidelity’s Jason Humphrey.
Humphrey, investment director for equity index funds (UK) at Fidelity, said it is understanding if investors are tempted to focus on the ongoing charges figure (OCF) when researching index funds but they need to be aware that there are several other factors that can have a significant impact on their investment outcomes.
“Logically, good client outcomes for equity index tracking funds should be judged less by OCF than by tracking difference – a measure of how closely a fund tracks its index – as this gives a truer reflection of the ‘cost’ of ownership,” he explained.
“However, comparing tracking difference between funds is complicated. It is therefore understandable that investors gravitate towards a lower OCF, but this does not give a full picture of the total cost of ownership.”
Below, Humphrey highlighted seven factors that investors should be looking at when researching index funds.
Index selection
The selection of the index is a crucial starting point, with Humphrey warning: “Be mindful of the differences in exposure between funds and indices that might be similar in name.”
This is essential to avoid overexposure or underexposure to some areas of the market when mixing and matching index funds, which can significantly impact the portfolio's overall risk profile and performance.
Costs and charges
While the OCF is commonly used when choosing an index fund, Humphrey advised a broader view. "You can screen on OCF, but don’t make that your only criteria," he said.
Investors should consider whether a fund’s OCF is fixed or variable as well as the impact of synthetic costs and transaction costs, which are not included in the OCF.
Understanding the manager's dilution policy and quantifying dilution costs are also key, as these can substantially affect the total cost of ownership. “Dilution costs can be many times the size of annual ongoing charges,” Humphrey pointed out.
Fund domicile and taxation
The domicile of a fund can have significant tax implications for investors. "UK-domiciled funds generally offer UK investors better withholding tax treatment than cross-border funds distributed into the UK," Humphrey said.
He also highlighted the importance of comparing the tax treatment of the specific index variant used by the fund to that of the fund itself for accurate performance measurement. “The index variant will not necessarily be apparent, so you might have to ask the question, but it’s important in assessing how accurate the reported tracking difference in fact is and therefore how this informs fund selection,” he added.
Valuation time
Investors should ensure that they are aware of any mismatch between the time the fund is valued and the time the index is valued as this will mean that any tracking difference or tracking error measurement is going to be inaccurate.
He also warned that investors cannot rely on third party vendor data or fund factsheets that do not take into account valuation time mismatches.
“For accuracy and comparability, ask for manager mid-priced, or unswung, market closing equivalent fund prices, and compare those to standard gross total return indices to level the playing field,” Humphrey said.
Liquidity
Liquidity considerations – essentially how easy it is to buy or sell a fund – are vital, especially regarding dealing holidays and advance dealing cut-offs, as these can impact the ability to reallocate funds efficiently and without time out of the market.
Fair value policy
Understanding a fund's fair value policy, or the methodology used to value securities when market quotations are not readily available or if events affect a security’s price when its market is closed due to time differences or local holidays, is another critical factor.
“Just because a prospectus says a manager can do it, doesn’t necessarily mean they do. You really need to ask for their policy,” Humphrey said. “Managers have to be careful not to be so transparent that they enable any arbitration of this investor protection, but they should be able to articulate their policy to provide comfort that it is being employed responsibly.”
Stock lending
The final aspect to consider is the fund's stock lending practices. This is when index funds lend out their securities, often to short-sellers, in return for a fee that can enhance the fund's returns.
“The key question here is whether you have sufficient ongoing transparency to be able to judge the reward versus the risk and complexity it adds to the investor proposition,” Humphrey finished. “We suggest you gain an understanding of the net uplift to the fund i.e. what’s in it for the investor and assess whether this is reasonable versus what the manager is taking.”