Investment research firm Morningstar has published a detailed research report comparing the costs of investing in exchange-traded products (ETPs) and traditional index funds.

TERs for equity index funds and equity ETFs have dropped on average during the past five years. The decline is largely a result of new products undercutting older ones.

Assets in European-domiciled ETPs and conventional index funds have grown considerably during the past five years. However, on a comparative basis, ETP assets have grown at a faster pace.

Morningstar data shows that total ETP assets as of 30 June 2013 totalled EUR 272 billion, up 205% from EUR 89 billion as of 30 June 2008. Over the same period, total assets in conventional index funds have risen about 80% from EUR 134 billion to EUR 254 billion.

The report, authored by Morningstar’s European Passive Funds Research team, provides a comprehensive, comparative analysis of the costs of investing in ETPs and index funds across different asset classes and sub-asset classes. The report focuses on the most visible component of the total cost of ownership: the total expense ratio (TER), and also discusses the less visible costs of passive fund investing that investors should consider for a more complete view of the total cost of ownership.

Key findings of the report include:

• Across all equity and most fixed-income exposures, ETPs are, on average, less expensive than index funds when measured against the latter’s retail pricing structure. However, ETPs tend to be more expensive than index funds when measured against the latter’s institutional pricing structure.
• The asset-weighted average expense ratio for equity exchange-traded funds (ETFs) is 0.39 per cent; this compares favourably to an average of 0.73 per cent levied by the retail share class of index funds, but stands above the 0.32 per cent charged on average by the institutional share class of traditional index mutual funds.
• TERs for equity index funds and equity ETFs have dropped on average during the past five years. The decline is largely a result of new products undercutting older ones. The biggest decline was registered by funds providing exposure to developed market equities. For example, in simple average terms, the TER for European large-cap ETFs dropped from 0.40 per cent to 0.32 per cent, while the TER for retail share class of index funds decreased to 0.85 per cent from 0.96 per cent.
• While fees have generally declined, about 40 per cent of European large-cap equity conventional index funds’ retail share classes still levy a TER greater than 1 per cent.
• Among ETPs, asset-weighted TERs for the majority of equity categories and for all fixed-income categories are almost always higher than the corresponding simple TER average. This implies that the majority of ETP investors are not necessarily choosing the cheapest options, as measured in pure TER terms. For example, the simple average TER levied by European mid- and small-cap equity ETFs is 0.41 per cent, but goes up to 0.44 per cent when measured in asset-weighted terms. Equally, in the case of European corporate bond ETFs, the single average TER is 0.21 per cent, whereas the asset-weighted TER is 0.23 per cent.
• Within Europe, the UK is the most competitive market for retail index funds that provide equity and fixed-income market exposure, followed by Germany, France, and Italy.
• A variety of dynamics is expected to keep expense ratios low; the growing popularity of passive instruments for all types of investors, helped by regulatory changes, is expected to fuel fee competition in Europe.

Commenting on the findings, Jose Garcia-Zarate, senior fund analyst on the passive funds research team at Morningstar, said: “The growing popularity of passive instruments appears to have triggered a fee war in Europe. A few fund sponsors have already started cutting fees on a number of core index funds and ETFs to make them more competitive, and more should follow. As the European index-tracking industry continues to grow, we expect fund sponsors to share economies of scale with investors, resulting in lower fees. We also anticipate more proactive, competitively driven fee reductions from fund sponsors seeking to grab the attention of investors.

“Cost pressures will also likely spread to other areas of the value chain, with ETF and index fund issuers continuing to pursue ways to reduce index licensing fees—such as changing index sponsors or self-indexing—and we would also hope sponsors would share those savings with investors. We would expect that this cost competition in the passive space will also increase fee pressure in the realm of actively managed mutual funds—a positive externality that could ultimately benefit all fund investors.”

The full report is available here: Every Little Helps: Comparing the Costs of Investing in ETPs versus Index Funds.