We take a closer look at the charges on Vanguard's funds.
When low-cost customer-owned fund manager Vanguard finally arrived in the UK earlier this year, it's fair to say that the imposition of an upfront charge of 0.5% caught many UK would-be investors off-guard.
After all, weren't Vanguard -- and its celebrated founder, John Bogle -- famous for leading the pack in terms of offering investment funds without upfront charges? Indeed, in books such as "Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor", hasn't Bogle himself argued vociferously against funds carrying 'front-end loads'?
So what's going on?
Stamp Duty Reserve Tax
It was a question that was wearily familiar to Peter Robertson, head of retail at Vanguard UK, when I spoke to him recently.
Let's start with the facts. Of the eight funds that Vanguard has launched, only two carry this upfront 0.5% charge. The two in question are the FTSE UK Equity Index and the FTSE UK Equity Income Index. Other funds, such as Vanguard's US Equity Index, don't carry the charge.
And that provides a clue as to what is going on. For the upfront 'charge' isn't really a charge at all -- it's a tax, and one levied only by Her Majesty's Revenue and Customs.
In fact, it's a tax called the Stamp Duty Reserve Tax (SDRT). It's payable whenever UK stocks are bought, and whenever the shares of a fund investing in UK stocks are redeemed and subsequently re‑issued. In short, when you buy a tracker -- from any provider, not just Vanguard -- SDRT is payable.
And, once again homing in on Vanguard in particular, the firm is keen to stress that it doesn't get to keep any of the money that it charges investors by way of SDRT. It all gets handed over to HMRC.
Buy-and-hold versus churning
One useful fillip to come from charging SDRT upfront is that it rewards purchasers of Vanguard's UK-based trackers who hold them for the long term.
"As the charge relates to the activity of individual investors, long‑term investors don't subsidise those who invest for a shorter duration," points out Mr. Robertson.
Well, I'm all in favour of that. As a net buyer of index trackers, why should my investment in a particular tracker subsidise the trading of other investors who buy and then sell out? It's not only nonsensical, it's unfair.
By making every investor pay what is in effect their own SDRT, it seems to me that the Vanguard approach is fairer. I pay my SDRT; you pay yours.
Tracking error
One popular misconception, explains Mr. Robertson, is that levying SDRT in this way is some sort of wheeze for achieving the sort of ultra low-cost annual fund management charges and Total Expense Ratios (TERs) that Vanguard is known for.
Nothing is further from the truth, he insists. For the Financial Services Authority clearly mandates which costs fund managers can and can't roll into their calculated TERs -- and the plain facts of the matter are that SDRT isn't an allowable expense when calculating a TER.
"SDRT is part of the transaction costs of running a fund and so is excluded from the FSA defined method of TER calculation: we could remove the SDRT levy from our charges, and still have exactly the same TER as now -- although it would eventually show up in the tracking error," says Mr. Robertson. "Having long-term investors subsidising short-term ones doesn't fit with our values or our desire for low tracking errors -- so instead, we have a charge that many others don't, and we spend a lot of time explaining it."
Now, regular readers will know that when it comes to index trackers, high costs sap your returns. That's why Fool writers regularly sing the praises of trackers with low charges.
Less often mentioned are the performance-sapping effect of tracking errors. Now, some element of a typical tracker's tracking error is exactly that -- especially in the case of FTSE All-Share trackers, where holding the entire index is not feasible, and so fund managers hold a representative sample of it instead.
And if that sample turns out not to be representative, then -- hey presto -- tracking error arises.
But, as we've seen, costs that can't be included in the TER also go to make up the tracking error. In this case, SDRT.
A tax I like to pay
And this is where I think Vanguard have been especially clever in levying SDRT upfront. Not only are they rewarding investors who hold for the long-term -- by not making them pay for the buy-and-sell tactics of others -- but the implied promise is of a lower tracking error.
I like that. A lot. At a stoke, I stand to benefit twice -- firstly by improved performance from a lower TER and annual charge, and secondly by the prospect of a lower tracking error. It's a message that I think investors will warm to as more people come to realise the full import of what Vanguard have done.
Will other tracker providers follow Vanguard's lead? Who knows? Don't forget, Virgin still charge a 1% annual management charge -- a cost its investors seem surprisingly relaxed about paying.
But it's been enough to persuade me. Next time I write a tracker article with the word 'Vanguard' in, I expect to have to disclose that a Vanguard tracker is part of my portfolio.
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