“I am considering buying an iShares S&P 500 tracker exchange traded fund. In the United Kingdom where I live, the annual total expense ratio is significantly higher than the exact same fund if I buy it on an American exchange. Why does an identical exchange traded fund (ETF), from the same provider, have a different expense ratios in different countries?”
That is a question recently posed by a reader. A very good question.
A few thoughts in response.
iShares S&P 500 Tracker
The questioner cited U.S. and U.K. versions of the iShares S&P 500 tracker index fund.
The U.S. listed S&P 500 ETF trades under the symbol IVV.
The U.K. listed S&P 500 ETF trades under the symbol IUSA.
Both ETFs track exactly the same index and come from the same ETF provider, iShares.
IVV, the U.S. listed ETF, carries an annual expense ratio of 0.07%. Extremely reasonable. Yet IUSA, the U.K. listed equivalent, has an annual expense ratio of 0.40%. Almost six times the identical U.S. ETF.
Expense Ratios are Ratios
No, not being flippant. This is actually an important thing to remember.
ETFs, mutual funds, even individual companies, all incur costs to operate.
Some costs are variable. That is, the costs only occur in relation to some activity. Every trade you make, you pay a transaction fee. Every widget your factory produces has a specific cost component. Do not trade or manufacture that widget, no expense is incurred.
Some costs are fixed. If you manufacture widgets, you need a factory. You need the factory whether you produce one widget or a million. Same with funds. You need a fund accountant, marketing literature, etc., to operate. The smaller the fund, the less you can spread out the costs. To coin a phrase, let’s call this “economies of scale.”
IVV has assets under instrument (AUI) of USD 42 billion. At 0.07% expense ratio, its “costs” are USD 29.4 million. IUSA has only USD 12 billion AUI. At the higher expense ratio of 0.40%, its fund costs are USD 48 million. 63% greater than IVV expenses in hard dollars.
Higher, yes. But not at the same level as indicated by the enormous spreads between expense ratios (0.07% versus 0.40% or almost 6 times).
When comparing expense ratios between mutual funds or ETFs, always consider fund size.
The smaller the fund, the less fund costs can be spread out over more investors.
IUSA is More Costly in Absolute Terms
Why does U.K. listed IUSA incur greater costs than U.S. listed IVV?
Both invest in the same holdings, the S&P 500. Both appear to follow the same replication methods. So why does IVV spend USD 29.4 million each year to run the fund, while IUSA spends USD 48 million?
Punishment towards U.K. investors? An incentive for them to move to Canada or the U.S.?
Undoubtably. But there may be a few other reasons. And these may apply to any funds registered in different jurisdictions.
Different jurisdictions may have different reporting requirements and/or require fund companies to incur varying costs to stay legal. The greater the amount of regulations and laws, the higher the cost to the fund.
Actual transaction fees to maintain index holdings may differ between jurisdictions. Taxes may also play a role in costs.
Marketing expenses, staffing costs, and all other associated expenses necessary to maintain a fund are impacted by where the fund is physically located and sold.
Although IUSA is USD denominated, there are still exchange issues. Just because the ETF is USD does not mean the fund accountant or marketer is paid a USD salary.
As well, there are costs involved in cross-currency transactions.
Never assume that a top rated ETF (or mutual fund) will have the same cost regime in all jurisdictions. Before buying a fund in your own country, do your due diligence.
Maybe the largest factor in costs is competition between providers.
The greater the number of mutual fund and ETF providers, the greater the price pressure.
There are many fund providers in the U.S. As a result, competition is intense. For simple index funds, cost minimization is crucial for investors. If you compared two identical funds, you would always choose the lower cost option. At least I hope you would! To be successful in attracting investors, these providers know they must offer the lowest cost funds (and funds that accurately track the designated market).
Fund providers in competitive markets are constantly looking for ways to reduce costs. These include: finding easier (i.e., less expensive) indices to track; using temporary expense cuts to attract new money; using low cost funds as loss leaders and then providing complementary (more profitable) products and services.
If you live in a country with limited competition, expect to pay more for funds. Or consider the pros and cons of buying your funds on an exchange in another country.
Also, keep an eye on changes in your home market. For example, iShares appears to be expanding its global footprint. That may signify future ETF fee reductions in the United Kingdom and other European countries.
Lessons to be Learned?
Probably a few takeaways.
1. Total Fund Costs Are Spread Amongst All Fund Investors
Your share of annual fund expenses is directly related to the fund’s asset size. Ceteris paribus, if you want a low annual expense ratio, seek out extremely large funds.
As an aside, extremely large funds are essentially the market themselves. Good for passively managed index funds. Not good for actively managed funds.
If you want an active fund, I suggest you endure the higher expense ratio and find a small fund. One that can be agile and where relatively small investments in a particular investment can impact overall fund performance. Perhaps focus on active funds that target niche, neglected, or inefficient markets.
2. Different Jurisdictions Require Different Costs
Regulations, legal requirements, the cost of living, salaries, transaction costs – all of these things (and more) impact a fund’s cost structure in a specific jurisdiction. That means there will be cost differences between the same fund offered on different exchanges. Do your due diligence when investing. A fund that may be a good investment in the U.S. may not be as good an option in the U.K.
3. Consider Investing Via Foreign Exchanges
You may be able to arbitrage. What I mean is that if you are able to buy an investment product in another jurisdiction at a cheaper price, consider that. In our example above, IVV is a better deal than IUSA. Why not buy IVV and save some money on fees each year?
If you can purchase the same product cheaper elsewhere, definitely consider it. But be careful. There are many nuances to consider and many are country specific (so I cannot enumerate them all).
For example, perhaps your tax-deferred investment account has restrictions on foreign content. A fund purchased in your home country would qualify. The identical fund purchased on a foreign exchange would not. In Canada, many brokerage houses allow for purchases on Canadian and U.S. stock exchanges. But only a few online brokers allow for purchases on the Swiss or Hong Kong markets. Depending on your broker, you may have limitations on where you can access investments. Also, those brokers that do allow trading on foreign exchanges usually charge a premium for transaction fees.
Another issue to consider is taxes. Buying a fund on a foreign exchange may result in taxes withheld at the source. Many countries will have reciprocal tax agreements, so you will not be double taxed, but it increases paperwork. Or, your domestic issued fund may send you nice tax receipts each year to aid in your personal tax preparation. You probably will not get the same information from a foreign issued fund. Again, that may increase paperwork.
Bottom line, investing in a fund on a foreign exchange may be cheaper in annual fees. But you need to consider other relevant factors that can increase both real costs and aggravation.
4. Low Cost is Great, But the Fund Must Track the Index
Net performance versus the benchmark for an index fund is a function of cost structure and tracking error.
Yes, you want to minimize cost. But not at the expense of performance. You need to make sure that your fund accurately tracks its benchmark index.
Investopedia has a nice little article on ETF Tracking Errors, if you wish to learn a little more on tracking errors. I like the article, if for no other reason, it starts out, “Although rarely considered by the average investor, tracking errors …” And the last thing I want is for readers of this blog to be simply average investors.
5. Continued Globalization Aids Investors
As the world continues to shrink, fund companies will move into neglected markets (like the UK). That should result in lower costs to core products as well as a wider range of offerings. Also, brokerage houses will allow for better cross-border trading that will further improve investing efficiencies and effectiveness.
Or, for my U.K. readers, feel free to relocate to North America. Less rain and fog, our airports do not shut down at the first snowflake, and much better food options than bangers and mash.