Investing: 'False economy' of lower fees amid US dominance

The cost of dealing, commission or spread always ended up as being insignificant compared to the impact of the investment decision.

Last year, according to the London Stock Exchange, investors withdrew £15.13 billion from active UK strategies. In April 2003 UK investors held around 66% of their assets in equity funds. Today it is less than 50%.

Alternative assets have no doubt taken some share, but the biggest impact has been the use of ETFs (exchange-traded funds). These funds have, rightly, displaced many active funds that charged high fees for a portfolio very similar to that of the index. With annual costs of around 20 basis points for the most popular global equity ETFs, they have provided low cost and strong performance.

However, financial products are often undone by their own popularity, and they rarely provide a free lunch forever. The largest indices that passive funds follow are now heavily skewed towards a few countries, companies and sectors.

The US now dominates. The MSCI World Index, which should maybe be renamed, has over 74% exposure to the US, with the top 10 holdings being US companies, including all of the Magnificent 7 (Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia, and Tesla). This is way beyond the US’s share of global GDP which is closer to a third.

While share prices should follow earnings, not GDP, corporate valuations must still be anchored to something real for them to make sense. Accordingly, the US appears over-represented in this index and does not provide the diversification that some investors might expect.

These products may also have implications for investors seeking regular cash returns. US companies are well-known to prefer buybacks to those in other regions, and the dividend yield on the S&P 500 is now barely above 1%. Not only do buybacks increase the risk of market timing, but the lack of dividends hints at another potential unpleasant surprise – earnings per share can be far removed from cash per share.  

Indices can also contain companies with a different problem – paying out too much cash. This is especially the case in high yielding sectors that often take on too much leverage and end up cutting their dividends. It might cost slightly more to ensure that an income-focused portfolio is prudently spread out, and with healthy growing dividends, but that is a price I consider well worth paying.

The most dangerous periods in financial markets are often preceded by a common condition: everyone crowded in the same room, and someone shouts fire. Lower expenses are in everyone’s interests, as are more choice and competition. But not if it comes at the cost of patience, due diligence and common sense.

There are important and perhaps unintended consequences when investing in index ETFs. If they result in the wrong decision at the wrong times, they will almost always outweigh any minimal savings in annual fees.

Graham Campbell is co-manager of the RGI Global Income and Growth Fund