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Index funds are cheaper than ETFs

We’ve previously looked at how you should buy index funds not ETFs if you want to invest in the simplest products possible (and remember, there’s nothing wrong with simple!)

Low-cost index funds also win hands down against ETFs if you make small, monthly investment contributions.

The decisive factor here is dealing fees.

Dealing fees are charged by online brokers every time you buy or sell an ETF. But they are not applicable to most index funds.

These dealing fees can gobble up a huge amount of a modest monthly contribution, and so torpedo returns in the long term:

  • You might expect to pay £10 in dealing charges on a trade – or at best £1.50 (on purchases) if you sign up to a regular investment scheme.
  • £10 in fees would slice 20% off a £50 contribution. Deadly! It’s still an unacceptably high 3% in the case of the regular investment scheme.
  • I wouldn’t contribute less than £300 on a monthly basis to an ETF in a regular investment scheme. This reduces the dealing charge to a manageable 0.5% of the investment.

For any small investor who wants to pay into a diversified portfolio every month, it’s pretty easy to see how dealing fees make multiple ETF trades unaffordable.

On Expenses

The other major cost consideration is which kind of tracker has the best Total Expense Ratio (TER)?

In the UK, the cheapest index fund usually trumps the cheapest ETF on TER, at least when it comes to the broad market indices that passive investors paddle in.

If you do find an ETF with a lower TER than a rival index fund, then you can do a quick battle of the costs (including dealing fee) by using a Fund Cost Comparison Calculator.

Just scroll down to find the calculator and type in your dealing fee percentage in the initial charge box.

Next part: What about tracking error?

Take it steady,

The Accumulator

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{ 6 comments… add one }
  • 1 tony November 6, 2011, 11:34 am

    Hi, TA. Good post. Your posts, coupled with Tim Hale’s book, have given me a really clear set of ideas as to how to invest.

    Overall, I’m putting everything in passive funds. I’ve only been investing for a few months; once I’ve got a sizeable portfolio, I might start having 10% “fun money”, invested in fashionable active managed funds, just to play around a bit.

    I have a question about this post though. In the UK, the reason someone like me would choose ETFs is because of the poor range of index trackers. Monevator has discussed this in various posts.

    For example, if I want property, the only OEICs are active managed ones.

    How do you reconcile the costs vs diversification issue? If I only think of costs, I’d likely narrow down my portfolio (for example, not investing in a property fund because there are no passive trackers), which increases the risk of losing money (or, reduces my risk of not losing money).

    I’d decided that I was going to try to save up £500-1000 at a time to dump in single ETFs. Not ideal, because you don’t get the advantages of drip-feeding, but as you say, you need to reduce the impact of charges.

    In the end, would you prefer to pay the extra dealing fees so you have a more diverse portfolio consisting of a broad range of products, or a narrower portfolio with zero dealing fees?

    I’m at an early enough stage of investing (although, at 42, not an early enough stage to have started) that I can take my time to make decisions.

    I suspect this is a “your mileage may vary” question. A broad set of index trackers should be good enough. I’ve got L&G gilts, L&G emerging, HSBC as above plus FTSE all-share. I’m missing commodities and property, however, so it doesn’t seem possible to get even a truly broad portfolio using only index trackers.

    Thanks!

  • 2 The Investor November 6, 2011, 11:52 am

    @Tony — There are passive vehicles for property. iShares IUKP tracks a basket of UK-listed REITs such as Land Securities and British Land.

  • 3 tony November 6, 2011, 12:25 pm

    Hi TI – thanks! I’d been looking and looking, and I’ve no idea how I missed that.

  • 4 tony November 6, 2011, 12:32 pm

    Ah, hang on, that’s still not an OEIC though is it? According to Morningstar it’s an ETF. Might be talking at cross-purposes here; I’m talking about the ability to get a diverse portfolio using only OEICs where possible, to allow drip-feeding and avoid dealing fees.

  • 5 The Investor November 6, 2011, 1:32 pm

    Yes, sorry, I skipped past that element of your post. Sunday head! 😉 Still why not open a Halifax or other service allowing £1.50 investment fees and get property via an ETF? You could debit out say £50 a month and invest it every three or six months say.

    Don’t let perfect be the enemy of the good I say…

  • 6 The Accumulator November 7, 2011, 10:12 pm

    @ Tony – I’d personally prefer to pay a bit extra to diversify into an asset class like property. Though you’ll find plenty of model portfolios that skip property entirely. Like you I save up enough to put into an ETF and reduce the impact of dealing fees, and, over the long-term it’s still drip-feeding even if you’re only doing it annually.

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