For professional clients only

Beyond the headline price: Total cost of ownership (TCO) of tracker funds

Good value or high maintenance?As investors and their advisers continue to focus on cost efficiency, the fund management industry has been working towards better transparency of all retail fund charges.

Over the years, there have been a few changes in the way fund costs are looked at and compared. More recently, regulators, fund providers and the financial media discussed the Total Cost of Ownership (TCO) as an all-inclusive figure which may potentially become a gold standard for fund due diligence.

In this publication, we examine the composition of the TCO and look at why it should be considered in the course of index fund selection.

Tracking difference

What’s in the figure?

Given that the TCO is an all-inclusive figure, let’s first look at some of its main constituents.

There have been different ways of analysing fund charges and costs. For many years, the key measure for most retail funds was considered to be the Total Expense Ratio (TER) which has been replaced by the Ongoing Charges Figure (OCF). The OCF covers the fund’s Annual Management Charge (AMC) and other operating costs, such as the fees paid to the trustee (or depositary), auditor and regulator, all over a one year period.

Costs of owning the fund

Costs of selling/buying

the fundCosts of selling/buying

the fund TCO+ =In many ways, the OCF has become a key figure used to compare the charges levied by different funds. However, it is important to remember that the OCF does not cover all the charges, the most important of which are dealing costs of buying and selling stocks within the fund (please see table 1). These costs are particularly important in the context of passive investment as they form a significant part of tracking difference – the difference between the performance of the fund and the index it aims to track. That is why we believe that the TCO, which unlike the OCF includes dealing charges within the fund, should be considered when comparing tracker funds.

Table 1: What is covered by the OCF?

Cost Included in the OCF?

Annual management charge Depositary fee Custodian fee Costs of distribution Audit fee Registration fees, regulatory fees and similar charges Interest on borrowing Fund’s brokerage charges Fund’s dealing costs Entry and exit charges

Make the TCO part of your index fund due diligence

In the post-RDR environment, there has been a bigger focus on cost efficiency and better transparency of fees and charges. Clients expect their advisers to present them with total fund costs, i.e. those that include not only running costs but also any fees and charges of buying and selling the fund.

Tracking difference: the cost of owning the fund

The most popular index funds tend to be cheaper than their peers. Tracking difference is a key metric of cost efficiency, which is lower for cheaper funds. Tracking error is then used to establish how consistently the fund tracks its benchmark.

Tracking difference includes a proportion of fund returns that goes to pay for the running of the fund itself. Tracking difference is typically expressed as a negative figure because the fund usually ends up lagging its index by a small margin.

Much of tracking difference comes down to the ability of the fund manager to efficiently replicate an index and minimise trading costs. Trading costs cover the expense of buying and

Table 2: Tracking difference: an illustration for HSBC index funds

Fund BenchmarkFund

performance*, %

Benchmark performance*,

%

Tracking difference, %

OCF**, %

HSBC American Index Fund S&P 500 Index 6.1 6.9 -0.8 0.08

HSBC European Index FundFTSE All-World Developed Europe ex UK Index

0.2 0.9 -0.7 0.10

HSBC FTSE All-Share Index Fund

FTSE All-Share Index 0.5 0.6 -0.1 0.07

HSBC FTSE 250 Index Fund FTSE 250 Index 12.2 12.8 -0.6 0.18

HSBC FTSE 100 Index Fund FTSE 100 Index -2.1 -1.9 0.2 0.18

HSBC Japan Index Fund FTSE Japan Index 13.3 13.9 -0.6 0.21

HSBC Pacific Index FundFTSE World Asia Pacific ex Japan Index

-9.5 -9.1 0.4 0.25

Source: HSBC Global Asset Management. *Fund performance over 12 months to 30 November 2015, net of fees (OCF), net income reinvested,for the Retail share class. Given that HSBC prices its funds at midday, for the purpose of this table unofficial fund prices are used that are calculated at the close of business, consistently with the FTSE indices tracked. **OCFs are estimated and include the licence fees that will apply from 14 December 2015. Past performance is not an indication of future returns.

The OCF is part of tracking difference

selling stocks as part of index fund rebalancing and consist of commission paid to stockbrokers as well as any taxes due in the course of those transactions. If we look specifically at UK equities, for example, the Stamp Duty Reserve Tax (SDRT) will be the biggest of trading costs (please see our flyer on how we charge the SDRT on HSBC tracker funds).

Table 2 compares OCFs with tracking difference for a range of index funds from HSBC Global Asset Management. It shows that the OCF typically accounts only for some of the fund’s tracking difference. This also points to the importance of looking at tracking difference alongside the OCF when comparing fund costs.

And that is what the TCO can deliver, in contrast to the OCF and tracking difference, neither of which covers the cost of buying or selling the fund itself. Index fund investors may become liable for entry and exit charges that do not form part of the OCF.

This is why more and more advisers now use the TCO to conduct due diligence. It is relatively easy to calculate, and gives an effective way of measuring and comparing cost levels for different funds.

All inclusiveThe cost of rebalancing

Trading and tax costs are typically lower for index-based funds compared to active funds since they change their investments less frequently. However, these costs constitute a key part of any fund’s running expenses, being dependent on the turnover rate of the underlying index during rebalancing.

Rebalancing in the fund is mainly driven by periodic rebalancing of the index (usually quarterly), interim index changes, as well as corporate actions. The extent of how much change rebalancing brings to the portfolio is reflected in the turnover ratio.

For an equity index, a high turnover means that a large proportion of its constituent stocks are added and removed as a result of rebalancing in the course of 12 months. The turnover ratio represents the percentage of stocks that change every year. So if one tenth of an index’s exposure was replaced over a certain period then a turnover ratio is 10%.

If a particular index has a relatively high turnover ratio, any fund aiming to track the performance of that index will be faced with higher trading costs. As trading costs come out of fund performance, fund returns will be negatively impacted.

Some indices have higher turnover rates than others. There are many different reasons for that but it may well be a good idea to take indices’ turnover ratios into account, making sure that only benchmarks with similar characteristics are included in index fund selection.

Day 1 Day 2

££

Portfolio

Liquidity (does not affect portfolio turnover)

Market access through physical replication (affects portfolio turnover)

Managers can reduce their portfolio turnover on index funds by keeping a small portion of the portfolio in cash as a reserve to account for the difference between daily subscriptions and redemptions over a short period of time. In the meantime, fund managers use futures to maintain the fund’s market exposure at an acceptable level.

Know the price

The OCF has become the standard way to compare fund costs but advisers should not rely entirely on this measure in their index fund due diligence. This is mainly because trading costs, which form a large chunk of investors’ cost of fund ownership, are not included in the OCF.

We would argue that when it comes to comparing fund costs, tracking difference should also be taken into consideration as it demonstrates portfolio managers’ skill to reduce fund costs and keep volatility under control.

A growing emphasis on transparency of fund costs has also underscored the importance of the TCO, which can be used in fund selection as an all-inclusive figure. Importantly, the TCO comprises not only dealing costs within the fund and all the OCF costs but also the costs of buying and selling the fund itself.

Good index fund due diligence should give investors a picture of the total cost of investing in an index tracker over a year, as it ultimately represents the hurdle in the market which must be overcome before the investor starts making money.

Table 3: Managing Portfolio Turnover through Liquidity

Notes

Notes

ContactFor more information, please contact us:

Email: broker.sales@hsbc.com

Telephone: 0800 358 3011

Website: www.assetmanagement.hsbc.com/passive

Important InformationThis document is intended for Professional Clients only and should not be distributed to or relied upon by Retail Clients. The HSBC index tracking funds referred to overleaf are sub-funds of HSBC Index Tracker Investment Funds, an Open Ended Investment Company that is authorised in the UK by the Financial Conduct Authority. The Authorised Corporate Director and Investment Manager is HSBC Global Asset Management (UK) Limited. All applications are made on the basis of the HSBC Index Tracker Investment Funds prospectus, Key Investor Information Document (KIID), Supplementary Information Document (SID) and most recent annual and semi annual report, which can be obtained upon request free of charge from HSBC Global Asset Management (UK) Limited, 8, Canada Square, Canary Wharf, London, E14 5HQ, UK, or the local distributors. Investors and potential investors should read and note the risk warnings in the prospectus and relevant KIID and additionally, in the case of retail clients, the information contained in the supporting SID. The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Where overseas investments are held the rate of currency exchange may also cause the value of such investments to fluctuate. Stockmarket investments should be viewed as a medium to long term investment and should be held for at least five years. HSBC Global Asset Management (UK) Limited provides information to Institutions, Professional Advisers and their clients on the investment products and services of the HSBC Group. This document is approved for issue in the UK by HSBC Global Asset Management (UK) Limited who are authorised and regulated by the Financial Conduct Authority. Copyright © 2016 HSBC Global Asset Management (UK) Limited. All rights reserved. 27740CP/ED1215/FP16-0046. EXP 13-07-2016

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