How to choose the best index trackers #2: Costs

This post is part of a checklist designed to help you choose the best index trackers for your portfolio.

The idea is that you can quickly whizz through the checklist whenever you need to buy a fund, and it will help you pick out the key features that should guide your choice. Part one covers the basics of choosing an index tracker.

This time, we’re looking at the vitally important issue of costs.

Keep costs low

Your return is eroded by costs, which are as manifest as the incarnations of the Hindu god Vishnu.

As real UK equity returns historically hover around the 5% mark, every extra slice salamied off your return is a kick in the chutneys for your future self.

Look out for the following costs and squeeze them hard.

Ongoing Charge / Total Expense Ratio (TER)

A fund’s Ongoing Charge or TER includes its annual management fee plus other bits and pieces. While important, the Ongoing Charge is sadly not a full picture of a fund’s costs, as we’ll see in the rest of this post. The Ongoing Charge is a quick and easy number to compare against other funds, but it’s not the be all and end all.

• Under 0.2% is good for a broad UK equity or gilt fund.
• Under 0.4% is good for developed world funds.
• Under 0.5% is good for emerging markets.
• Over 1% is a rip-off.

Take a butcher’s at our pick of low Ongoing Charge funds.

Tracking error

Index funds should hug their index. If the FTSE 250 returns 5%, then theoretically so should its tracker (minus fees).

In practice, fund returns can deviate from their index for all sorts of reasons. If they do so regularly, and with gusto, then bad management may be at work.

Every time a tracker returns less than its index, that’s a real cost to the investor, so check a fund’s tracking error (or more realistically tracking difference). Unlike Madam Spank’s rubber parlour, the less deviation the better.

Portfolio Turnover Rate (PTR)

The more your fund buys and sells, the more return juice leaks away in the form of trading costs that aren’t accounted for in the TER. Check a fund’s annual report for its PTR. The lower the better. The median PTR for UK index funds is around 13%.

Initial fee

Don’t pay one for a tracker, unless you’re buying a Vanguard fund. Vanguard TERs are generally so low that they still beat their rivals even with the initial fee lumped in.

Dilution levies are an exceptional, benign form of initial fee. A dilution levy covers the cost of your entry into a fund rather than spreading it across your fellow investors as well.

While it may sting a bit, a dilution levy also means that you’re not paying the costs of other fickle investors trading in and out of the fund every five minutes. That’s a good thing for long-term passive investors, as long as the initial fee isn’t so high as to make the fund uncompetitive.

Redemption fee

A redemption fee is the opposite of an initial charge in that you pay up as you exit a fund. Like a dilution levy, this fee can be a good thing for buy ‘n’ hold investors, if the fund’s other costs are especially keen.

A redemption fee is meant to make market-timers think twice about flitting out of the fund, thus incurring trading costs that are borne by everybody else. Redemption fees commonly taper off once you’ve held the fund for a certain length of time, and the fees should be fed back into the fund’s assets rather than snaffled by management.

Part three of the checklist covers the more often-overlooked aspects of index trackers.

Take it steady,

The Accumulator