It’s easy for passive investors to get wound up by the arrival of cheaper funds. We’re all about cost management, but should we leap like a lizard every time a new fund turns up with a slimmer Ongoing Charge Figure (OCF)?
We’ve previously looked at how to calculate whether the cost savings are worth the hassle of switching funds. But an even bigger consideration is the chances of wild and dangerous Mr Market moving against us.
If you trade from one index fund to another then you’re likely to spend a significant amount of time out of the market due to the way the system works.
If you swap between two index funds that track the same index, this delay means:
- You will lose if the market – and so your new fund – rises in value between trades. The money you raised from selling your old fund will buy fewer units in the new fund.
- You will gain if the market – and so your old fund’s price – drops after you sell. Now the money you cashed out of your old fund buys more of the new fund’s cheaper units.
How long will you be out the market?
This depends on your chosen platform. Here’s TD Direct’s turnaround schedule:
- Submit your sell order in time to meet the fund’s valuation point that day. That’s anytime from 9.30am – 12pm, depending on your fund provider. Your old fund is flogged and you will receive cash in line with that day’s valuation.
- Orders that come in too late will be executed the following day.
- Now we’re in business, no? No. It takes up to four days for the fund to settle. In other words, it’ll be four days before the money goes all the way down the chain from the buyer to you. If you sold on Monday, it’s now Friday.
- Submit your buy order. If you missed the Friday morning deadline then your trade won’t go through until Monday. You’re out of the market for a week. Empires have fallen in less time.
Happily the dance doesn’t have to take that long. If you ring up TD Direct on the second day after the sale, it can tell you how much you raked in and will buy the next fund. Move quickly and you could get your buy order off that day. Your time out the market is reduced to two days.
Check with your broker for its own timetable.
Worst case scenario
Popping champagne corks at City trading desks are a fearful sign for us when we’re switching funds. A good day for the markets is a bad day for us if we’re not in the game.
The FTSE 100’s best day ever was a 9.84% rise on 24 November 2008. The second best day saw an 8.84% boost. I’ll use these movements to model our worst case two-day scenario: where the first rise was followed by the second. In reality that didn’t happen and no fund-hopping passive investor will have had a comeuppance quite this bad. Yet.
You can simulate these movements well enough by using Candid Money’s investment charges impact calculator to work out the effect of asymmetrical costs on each fund.
We’ll take a look at the impact of such an adverse market movement using the Salami Slicer example from our previous fund switching post. In this instance, our new fund is only a sliver cheaper than the old – it’s OCF is 0.2% versus 0.3%.
In this example, we have £1o,000 after we cashed out of the first fund. While we’re waiting for our money to go into the new fund, the market rises by that nightmare 9.84% on day one, followed by a “Why me!?” 8.84% on day two.
Our old fund would have been worth £11,954.991 if we’d just left well alone. Instead, we have a paltry £10,000 to put into the new fund, which has experienced the same accursed good fortune over the two days.
Still, we’ve got 20 years of cheaper OCFs to look forward to in the new fund. Let’s see what the trade-off has brought us:
Old fund OCF 0.3%
Fund worth £11,954.99
New fund OCF 0.2%
Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund value after 20 years of cost savings:
Old fund = £80,281
New fund = £75,432
You lose £4,849 or -6.04%.
The market swing against us – in just those two days – is something we never recovered from in this Doomsday scenario. That’s despite 20 years laughing it up with a slightly cheaper fund.
In contrast, an investor with all the dynamism of a cabbage ended up nearly £5,000 better off than us, because they did nothing. Our move proved to be the financial equivalent of blasting our own feet off.
So much for knowing all about the funky new funds.
Average case scenario
Okay, so far so ill-advised, but that was an extreme case. What might the markets do to us on a more average day?
To give us a rough idea2, I’ve had a grapple with daily pricing data for the FTSE All-Share index. Thanks Yahoo Finance!
Daily prices are available from 4 January 2000 to 11 January 2013, which is long enough for our purposes.
The average daily rise in the market was 0.658% during this period. The average daily fall was -0.603% and if you average out the gains and losses then the market moves a pitiful 0.004% per day.
Back to our example. We sold our fund for £1o,000, but this time the market carried on rising without us at 0.658% per day for two days before we were able to buy back in.
So our old fund was worth £10,1323 by the time we bought £10,000 worth of the new fund.
Old fund OCF 0.3%
Fund worth £10,132 (after two days average gain)
New fund OCF 0.2%
Fund worth £10,000 (no gain while in cash)
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund worth after 20 years cost savings:
Old fund = £74,757
New fund = £75,432
You gain £675 or 0.9%
Well, at least we’re up. After 20 years baking our investment pie with a lower OCF, we cash out slightly ahead.
In fact, after merely 10 years we’re up £19. Sound the vuvuzelas.
Whether such a (potential) gain is worth the risk and effort depends on how devil-may-care you are, how long you invest for, the actual difference in fund costs, how much you invest, and the return you get.
It’s pretty obvious though that there’s no need to sweat small stuff like this. Especially as keeping things simple is the essence of passive investing.
Hey, wouldn’t we profit more if the market fell?
Okay, calm down Gordon Gecko. To round out the picture, you’d indeed be £1,500 up if the market took an average dive (-0.603%) on both days.
Oh, and you’d be a smidge over £1,000 up if you averaged out the daily gains and losses to creep ahead 0.004% each day.
Intriguingly there was a 51.7% chance of a rise on any given day and a 47.8% chance of a fall. The market stayed flat 0.5% of the time.
Exchange Traded Fund (ETF) scenario
The ability to trade ETFs all day long makes them less risky than index funds when it comes to a quick switcheroo. You’ll lose a bit on the bid-offer spread, you’ll pay a dealing fee to buy and sell, but you need only be out of the market for a few minutes thanks to real-time online trading.
In the example below, I assume a bid-offer spread of 0.1% between my two funds. This is the cost of having to sell shares for slightly less than they’re worth and buy for slightly more than they’re worth so that the men in the middle can make a living. Think buying and selling foreign currency when you go abroad.
Our £10,000 holding is whittled down to £9,990.02 after deducting the cost of this 0.1% spread. That becomes £9,980.02 after subtracting £2o of dealing fees (one sell and one buy order).
I’m not going to worry about any change in price between the two trades. It would amount to pennies either way in a reasonably liquid ETF, assuming we’re not in the middle of a flash crash.
Old fund OCF 0.3%
Fund worth £10,000 (value if we’d just left things alone)
New fund OCF 0.2%
Fund worth £9,970.02 (after trading cost deductions)
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%
Fund worth after 20 years cost savings:
Old fund = £74,357
New fund = £75,340
You gain £983 or 1.32%
Well worth making the change, even considering the trading costs. (We’d only be a bit further ahead at £1,075 after 20 years if ETF trading costs were zero).
I’d definitely be more sanguine about switching liquid ETFs with tight-bid offer spreads, assuming I didn’t mind the bother and that I was trading at least £2,000 a pop. Remember ETF dealing fees can take big bites out of small trades.
Keep It Simple, Stupid
My two posts on this subject have definitely failed the KISS test.
The first post demonstrated that it’s definitely worth the trouble to switch from high-fee active funds to reasonably priced index trackers, but we knew that anyway.
The benefits of switching out of a tracker with a sub 0.5% OCF are far more debatable and taper away the less money you have, as well as exposing you to the risk of the market moving against you.
There quickly comes a point where jumping ship isn’t worth worrying about.
That said, even if two trackers seem similar in cost, it’s always worth comparing their tracking error. That’s the true measure of an index tracker’s cost and can betray some hidden truths that don’t show up in the OCF.
Take it steady,
The Accumulator
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Personally I would always be willing to pay a little more in charges for an ETF for the simplicity of being able to trade in minutes and easily find the share price
The only advantages of OEIC/unit trust funds that I can see are:
– you can have accumulation units in funds
– funds are less likely to use derivatives than etfs
I think the Vanguard etf trackers are lower cost than their unit trusts anyway?
@Neverland — Funds are also cheaper to buy than ETFs (well, free!) which matters when you’re working with small sums, especially if you’re regularly contributing new money: http://monevator.com/index-funds-are-cheaper-than-etfs/.
Some random thoughts:
1. If you are investing outside of an ISA and you’ve got say 10K in an easy access account then one way of avoiding the swings of being out of the market is to sell 10K of your OEIC or unit trust and purchase your new fund on the same day out of your 10K savings. Then when your sale settles replace the savings in your easy access account. You lose the interest on your 10K savings for a number of days but at least you aren’t subject to large market movements.
2. Also as has been mentioned before lots of little switches rather than one big switch can even out the fluctuations especially if you are not being charged for buying and selling.
3. Also worth watching out for single priced funds where the single unit price is swung higher when more people are buying in and swung lower when more investors are selling. That part of the stamp duty and transaction costs this is trying to recoup for the fund is effectively being recouped from those investors moving in and out. Less of a problem for growing funds like the HSBC all share tracker which seems to be consistently ‘swung up’ at the moment although no fund can grow indefinitely.
4. It is also worth keeping an eye on re-registration charges in choosing your platform to hold your OEICS, especially if you are holding funds in an ISA wrapper. Because it is not possible to easily use either of the techniques in 1. and 2. above with ISAs you are much more at risk of adverse market movements while the transfer happens. Thus you may not want to take that risk and will be looking to re-register funds in specie. Some platforms don’t charge at all for re-registering away currently such as Fidelity Fundsnetwork and the HSBC Global Investment Centre but many/most others charge per fund which can be expensive.
5. If investing in Vanguard funds with a SDRT levy then have a strategy ready for re-registering if you have to move to another platform. If you have to sell to cash out of those funds and buy back again you will lose the SDRT levy.
6. If you do instigate a switch try to avoid working out what you have lost (or gained) through market movements in moving say from one platform to another. If you work out you have lost out then you will just feel bad about it. Just accept it is part and parcel of keeping charges down.
@Investor
I don’t tend to buy in batches less than £5,000 a time so I guess my dealing charge, I think its £12.50, tends to get lost in the wash
@Neverland — I know what you mean and things are similar for me (though I do average in and out of specific shares on smaller amounts). Stamp duty and of course spreads are the costs that keep on giving, whereas cheap dealing fees do rescind as one’s wodge grows.
However this site is read by all sorts, at all different stages of investing. And I well remember when I was starting out the annoyance of totting up 5-6 trades in a month and realizing I’d spent over £100 on ‘air’, as I saw it then. 🙂
With TD, the two day turnaround is not only applicable by phone – it works online as well. Just because it takes 3 days to clear doesn’t mean you can’t get another holding – just that you can’t withdraw the money. They are about to clap on a significant dealing fee for phone trades, too. (I sold out of my IP japan holding to replace it with the no trail class. Yes I know TD rebate the trail commission and the fees will be the same after August but I think it is neater to avoid the rebate faff. Despite completely arbitrary timing I managed to be out of the market for a 4% fall, then back in just in time for a 4.5% rise! Whee! That event is probably enough to skew my eventual lifetime average!)
Note that when averaging into a stock you should put in equal amounts of money, whereas when averaging out you should sell equal amounts of shares.
I think it is a mistake to forget dealing charges. for a £5k holding, £12.50 will be the same as stamp duty as you need to sell at some point! Still, on any sensible timescale, ongoing charges are much more relevant. This is why I think some of the issues raised in the passive portfolio can be avoided – simply sell down an OEIC holding when it gets large and buy the corresponding ETF. Ok, that doesn’t really fit in with the “set it up and get on with your life” role it performs, but those people won’t really worry about the tiny margins we are talking about here!
Hi Monevator,
Not quite relevant, just wondering what is your take on SIPP accounts.
I’m thinking of opening one, but my major worry is: the govt at some point in the far future taking the SIPP savings to bail out people that didn’t save for retirement.
A Minor worry is what happens if current age at which you can withdraw the savings (55) moves to something insane in the next 30 years, eg 75, in which case I’m not sure it’s worth spending time to invest now just in case I reach 75. Locking in an amount now till then equals forfeiting opportunity cost.
I’m not asking for political predictions down a 30 year horizon, anything can happen till then. What I’d be interested in is if you are aware of which laws affect SIPPS, for how long has the 55 age limit been around ( if eg it’s the same since 1800, I’d feel somewhat on the safe side). Would I have any legal protection to claim the funds at 55, given that I opened the SIPP under current age limit ?
@K
Its really a matter of weighing the tax break (an immediate 66%/82% uplift in your investment in a SIPP if you are a higher/additional rate tax payer) versus existing lock-ins, the fact that you will get taxed on income you take from the pension when you retire and the fact that the government can just change the law and do whatever it wants, even if they promise not to in their pre-election manifesto
Private pensions as currently structured are just hugely more attractive to higher earners than basic rate tax payers and therefore the lions share of pension tax relief goes to the top 5% of eaners in the country – I don’t expect that to continue given the state of the country’s finances whatever the future government
Also I’ve been saving into my personal pension for c.20 years and I am now on my fourth major personal pension taxation regime…
…on the other hand I can confidently say I’ve postponed (and maybe even avoided 🙂 ) £000,000s of income tax to allow my investments to grow tax free in my SIPP and thats very valuable to me
@ Greg – I’m not talking about a phone trade. This is an online trade, but you need to phone up to get them to let you use the cash for another trade before it’s settled. I went through the details with TD specifically on this.
@ K – I really wouldn’t worry about a future you can’t predict or control. Err on the side of things you can control like lapping up the tax breaks. Just one thought, considering that the largest pension funds are held by the richest and most powerful members of society, I don’t think confiscation of your assets is a concern except under conditions of revolution. I also can’t see what would be gained by advancing the SIPP age limit. State Pensions cost the government less the longer they are delayed but assets built up in SIPPs relieve state burdens.
@ Snowman – all excellent points, particularly the one about not going back to check. I must say though, that having looked into it, I think I’m more likely to switch now if I see the opportunity to buy into a cheaper fund.
Interactive Investor told me that for the proceeds of a fund sale “Although you cannot withdraw the funds or move them between accounts until the trade has settled we do allow you to invest the funds straight away, as you quite rightly point out the subsequent trade will also take several days to settle.” I am not quite sure how this would work, because funds are forward priced, so you wouldn’t even know the precise amount of proceeds until the next valuation time. However, it does sound as if you need not be out of the market at all, with Interactive Investor. I have not yet tried doing this, but I do have a recollection of doing this at Alliance Trust Savings, although perhaps I misremember.
@K
Barring some sort of malign dictatorship, I don’t think it is likely that your pension assets would ever be overtly confiscated, but I do think there is a real chance that the tax treatment might be changed in a manner that effectively claws back of the tax benefits. This would be on the grounds that the then government is desperate for extra money to fund the state pensions and NHS costs of baby boomers who are due to retire over the next decade or two. I can foresee the possibility that if sufficient political pressure built, they might convince themselves that it was a mistake ever to give tax benefits on pensions and that as almost all of the benefit was in practice reaped by the richest in the country, it is only “fair” to claw back these tax benefits.
I’m not saying it will definitely happen. I’m not even saying it is likely. But I do think it is far from a negligible risk. Due to my unusual tax circumstances, the net benefit that I receive from pension contributions is much lower than most higher rate taxpayers receive, so I made the decision not to have a SIPP, because I don’t want to be hostage to future governments who might feel they have every right to make changes along the lines I have speculated about. If I was a normal higher rate tax payer, I would probably max out on the pension contributions and live with the risk that the goalposts might be moved in the future.
@ Ivan – I can imagine that some firms will have a quicker turn around than others, but I suppose you’d have to be out of the market for a minimum of 24 hours with funds due to the valuation points. You only know how much you’ve sold for at valuation point 1. The next trade is immediately ordered but will execute at valuation point 2 the next day.
While I can imagine the higher rate tax benefits being scaled down somewhat (we’re all in it together) I think there is a negligible chance of that happening to basic rate taxpayers. Remember the government needs more people to save for their pension, not less.
Interactive Investor have confirmed that when they say you can invest the proceeds of a fund sale straight away, what they mean is “when we receive the details of the price and update your account with the trade you can then trade with the cash from these sales. Your account is normally updated the day following the order if placed before 11am, or on day three if the order is placed after 11am.” So if you place the order in the morning you will be out of the market for one day.
ATS told me “the funds are not available until the Fund Manager confirms to ATS that your order has been executed. This can take approximately three days.”
@ Neverland – I think for long term investors there’s a few things to consider with ETF’s, including the trading costs. Most long term investors will want to re-invest dividends, and if you do you need to be aware if the ETF base currency is not GBP, because the distributions are paid to you in the base currency. This invariably incurs costs (which can be in the form of steep spreads) if you want to convert back to Sterling. You also have to pay trading costs for re-investing dividends, and some brokers limit their cheap dividend re-investment plans to only the most popular ETF’s, IF they allow them at all on ETF’s. If they don’t, then it’s a normal trade and it can work out pretty expensive to re-invest your divi’s.
There are a handful accumulator ETF’s now (e.g. iShares SWDA, SEMA, SACC) which get around this problem, but only for broad indices, not specialist or single countries. Also most of the db Xtracker funds track Total Return indices using swaps, rather than distributing income, although it should be noted swap based ETF’s do expose you to some counter party risk.
@ McLovin – I own multiple ETFs that are based in dollars and the distributions are paid in pounds. I get around divi reinvestment costs by throwing the divis in to my next regular trade.
@ The Accumulator – do you have an example of one? I own or have owned things like IUSA, IBZL, IEEM (all quite popular iShares ETF’s) which are traded in pounds on the LSE, but all pay distributions in US dollars. With TD Direct they are held as dollars, but perhaps other brokers convert them to pounds (although I suspect this would not be without cost).
Clearly the iShares website shows distributions paid in USD on the iShares MSCI Emerging Markets fund (as an example) – http://uk.ishares.com/en/rc/products/IEEM/distributions-and-yields
Incidentally a handful of UK listed shares pay dividends in foreign currency, for example Xstrata.
Sure, I own XGSD, base currency Euros, pays me in £.
http://www.etf.db.com/UK/ENG/ETF/LU0292096186/Stoxx%C2%AE_Global_Select_Dividend_100_UCITS_ETF.html
Also, IWDP, base is $, distributes in £.
http://uk.ishares.com/en/rc/products/IWDP
My broker is TD.
Are you sure about IEEM? The link says the base currency is $ and lists the yield in $ but so does IWDP.
Interesting point all the same though. I must be paying a currency conversion cost somewhere along the way, either via iShares or TD, but I have no visibility on that whatsoever.
Small update to this topic:
HSBC fund switch time out of market was 24 hours.
– S&S ISA in HSBC. I put in the switch order in the evening of 24 Feb. The sell order went through at 12:00 25 Feb, with that time’s valuation, and the buy order went through 24 hours later at 12:00 26 Feb, with that time’s valuation of the new fund. (Both funds price at 12:00 daily, with an 08:00 cutoff for trades)