Is it really worth trading in your index fund for a cheaper model?

If in doubt, go back to sleep

There’s not a lot to jump up and down about as a passive investor, which is why we tend to get over-excited around here whenever a new index tracker enables us to trim our costs by another 0.1%.

It’s rather like a retired detective deducing who ate all the cake at their kid’s birthday party. Our methods may seem extreme, but they help us to feel useful again.

The question is are we using a sledgehammer to crack a nut when we race to inform you that some tracker or another is now a smidgeon cheaper than last week?

Just how much do a fund’s costs need to fall before it’s worth selling out of the old and buying into the new and ever so slightly more efficient?

And should we bother to update the Slow & Steady Portfolio on account of cheaper funds? (Some readers think not).

Before we go on, investors who are new to the simple life of passive investing should avert their gaze now. You definitely do not have to go to these lengths to fine-tune your portfolio.

In fact, this piece is probably the most anal thing I’ve ever written.

It is strictly for hardcore investing life-hackers who are magnetically attracted to every infinitesimal advantage that crosses their path.

Numbers game

What we need to know is whether a new cut-price fund will make a worthwhile difference to our long-term investment prospects.

The numbers that matter:

  • The cost of holding the fund – Take into account the Ongoing Charge Figure (OCF), any initial charges, capital gains tax consequences1 and differences in dealing costs and platform fees.
  • Fund worth – The bigger your holding, the more you gain from OCF clipping.
  • Future contributions – See above.
  • Investment time horizon – The more years you hold, the more cost reductions compound to your advantage.
  • Return on investment – The bigger your pile, the more percentage fees like the OCF will cost you.

You can quickly use these factors to work out your savings with a fund cost comparison calculator. Let’s now use that calculator to rustle up a few illuminating examples of the impact of price pruning.

I’ll keep the numbers moderate so that it might represent the situation of a fairly typical small investor, rather than use a 40-year time horizon or similar to hammer home my point.

Example 1: Seeing the light

You get the biggest boost when the fee drop is pronounced, such as with a switch from active funds to passive funds.

Old fund OCF 1.5% 
New fund OCF 0.5%

Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%

Fund worth after 20 years cost savings:

Old fund = £62,676
New fund = £72,255

You gain £9,579 or 15.28%

That’s a lot of money that might as well be in your pocket rather than a fund manager’s. Especially when you scale that saving up across four or five funds in a portfolio.

Example 2: The Gillette switch

Now let’s look at a closer shave. The type you might make as a seasoned passive investor benefiting from tighter price competition in the tracker market.

Old fund OCF 0.5%
New fund OCF 0.25%

Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%

Fund worth after 20 years cost savings:

Old fund = £72,255
New fund = £74,892

You gain £2,637 or 3.65%

I’ll take that. It’s still a fair wedge, even though it may be 20 years off.

Example 3: The salami slicer

What about the kind of 0.1% finessing that prompted the wholesale switching of our Slow & Steady passive portfolio back in 2012?

Old fund OCF 0.3% 
New fund OCF 0.2%

Fund worth £10,000
Future contributions £100 a month
Investment horizon 20 years
Annual return 6%

Fund worth after 20 years cost savings:

Old fund = £74,357
New fund = £75,432

You gain £1,075 or 1.45%

£1,000 eh? Well, I’d definitely snatch your hand off if you gave that to me now. But that’s actually the gain you’ll make in 20 years time.

Just how much is that worth now?

The present value of money

The time value of money is a concept that helps explain our natural intuition that money gained in the future is less valuable than cash in the hand right now.

We can estimate how much the future £1,075 gain from the last example is worth to us now by using a present value of money calculator.

If I assume the same 6% interest rate and 20-year stretch, then the calculator tells me the present value of £1,075 is £335.

Whether you’re prepared to get out of bed for that kind of money is a personal choice. I am.

Let’s say it takes five hours to research the new fund, take a decision, make the trades and track the changes. And let’s say I charge out my free time at £20 an hour. That means that any switch that delivers more than £100 today is worth my time.

Using a future value of money calculator it turns out that £100 today is worth £321 in 20 years time. So any switch that saves me over £321 in 20 years is worth the faff (given my assumptions above).

Sorry, I told you this was beardy. And I must repeat that none of this is compulsory!

Previously I’ve always compared funds using the fund cost comparison calculator to decide whether a switch was worth the hassle. But there’s something about blogging that forces you to don your white coat and make matters more scientific.

Just one last thing

Sadly there is another factor you need to think about before you go a-switching, which is the risk of being out of the market while the transaction takes place.

If you invest in index funds then you can be sitting in cash for a few days, after selling the old fund and while you’re waiting for your broker to stop playing on Facebook and buy your new fund.

If shares surge in the meantime then the transaction will cost you more than you bargained for, because your cash in limbo will not be invested and so will not track the gains.

How much might it set you back? Needless to say, that’s complicated, but the short answer is – if you’re very unlucky – it might actually do more damage than paying slightly higher ongoing fees.

It’s potentially worth considering ETFs over index funds from an instant trading perspective if the risk of being out of the market feels like a biggie to you.

Take it steady,

The Accumulator

  1. See ivanopinion’s excellent comment 41 below

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