Tuesday, 23 July 2013

Why are sector funds so much more expensive than broad based funds?

If you invest in exchange traded index funds (ETFs) at all, you will have noticed that broad based index ETFs (which cover whole markets such as the Australian sharemarket or the US sharemarket) tend to have much lower expense ratios than those exchange traded index funds which cover specific sectors such as utilities, resources or financials.

I only recently started investing in sector ETFs after I saw an opportunity present itself in the resources sector a few months ago.  As I researched the possibilities though, the cost of the sector ETFs, especially in the Australian market really struck me.  Management expense ratio's are incredibly important when it comes to weighting up whether to invest in a particular managed fund (whether exchange traded or not).  In fact, over the long run it has a huge impact on your performance relative to the benchmark you are trying to beat.  The question therefore becomes:
Why do sector specific ETFs cost so much more than index ETFs?
I believe there are several factors which influence the MER for sector funds versus broad based index funds

Can I say upfront, that although I tried to research this I was not able to find any particularly good sources of information out there about why this is the case.  These conclusions are therefore my own. I am happy to be corrected on any of them or for additional reasons to be added.  If you have any suggestions please add them to the comments bar or send me an email and I'll be happy to include them.

I don't think there is any one defining factor which causes the costs for sector index funds to be higher than broad based index funds.  I think it is due to several factors which include:

  1. Sector ETFs are typically smaller and so transaction costs are higher as a proportion of funds under management
    • There is a significant difference between the size of sector index funds and broad based index funds. For example in the Australian market
      • One of the largest Australian broad based index ETFs, the Vanguard Australian Shares Index ETF has FUM of ~$416 million
      • One of the largest Australian resources index ETFs, the SPDR S&P/ASX 200 Resources Fund has FUM of ~$14 million
    • Index funds, in order to match index movements are constantly trading and the trading costs for a broad based index fund and a sector index fund are not likely to be significantly different, however as a percentage of their FUM, the difference is significant
  2. Broad based index funds are more easily able to hedge positions over the short term
    • Index funds are not always trading.  Although fund inflows and outflows theoretically mean that index funds should be constantly rebalancing their whole portfolio, this would result in trading costs being a very high numbers
    • Index funds typically use futures contracts to manage their cash flows until they have a big enough position built up so that they can hit the market and do the trades they need to do
    • It is much easier (and cheaper) to get a futures contract written on a broad based index than on a sector index which are much more specialised contracts 
Other reasons may include the higher cost to trade in illiquid stocks which may form a more significant part of a specialised index than a broad based index.  There is also an argument that if you are looking for a specialised product which is less available in the market, the chances are that you are willing to may more for this product and providers charge more on this basis.

Whatever the reasons are...you need to factor the extra cost into your decision to buy into this index

Index ETFs are generally appealing because they give you no more and no less than the market return at a cost typically much lower than the unlisted managed funds.  They are also a more effective way of accessing portfolio diversification than you going out and buying every stock on the exchange and managing it yourself.

However this argument starts to breakdown once you get into the more expensive sector ETFs.  If you look at the list of available ETFs on the ASX you can see the price difference.  The costs range from 0.15% for a broad based Australian market ETF to 0.40% for the cheapest of the resources ETFs.  This is a significant cost difference and one you should take into account when thinking about whether you want to invest in this product.

I made the decision to invest in the sector ETFs even though the cost was higher because I wanted broad based exposure to a sector, however I did not know enough about that sector to make a direct investment in stocks.  Make sure you go through this decision process before you invest though, as the management expense ratios really do impact your returns.

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