Why ETFs Are Unsuitable for New Zealand Investors

(by a former ETF manager)

Let’s correct a common misunderstanding – ETFs and index funds are not the same thing. The most popular Exchange Traded Funds (ETFs) do follow index strategies but whether a fund is listed on the stock exchange or not isn’t essential to owning stock exchange-listed companies via a fund that tracks an index.

Index funds, as demonstrated by countless academics, are the best choice for most investors. As an index fund manager we are strong advocates for index investing. However, holding index funds in an exchange-traded format depletes some of their benefits and affects the total investor return. In other words, they could be costing you more money than you might think.

There are three main reasons: tax, trading cost and drag.

If you'd like to watch a summarised video version of this blog, click the video above where we have Kernel founder and CE, Dean Anderson answer a few frequently asked questions.

It’s common that ETFs investing internationally end up not claiming all the tax credits, treaty benefits and refunds they’re owed. This is because either it’s hard work and doesn’t really benefit the fund manager, or the ETF doesn’t have the right structure to pass on these benefits to you as a NZ-based investor.

Now, you may think this tax “leakage” isn’t very important because it’s not often talked about. But depending on your personal tax rates and the investment strategy of the ETF, the tax leakage can sum to often be over 0.50%. For some funds we have seen as high as 1% per annum! A big expense each year that compounds over time and reduces your growth.

Paying too much tax

Unlike preferential tax treatment in other countries, especially the USA for US investors, NZ ETFs are classified as a listed PIE fund. 

This means that each distribution (dividend) from the fund is automatically and immediately taxed at 28% – the highest Prescribed Interest Rate (PIR). Because of this, any investor with a lower PIR immediately pays too much tax, which they can’t request back from the IRD until the following May via a tax return. If you are investing in an overseas ETF, the tax rate is your income tax rate which for many is 33% or 39%.

Potential lost growth

The ETF practice in New Zealand is that tax is deducted from the distribution immediately and sits as cash within the fund. This isn’t eligible to be distributed to investors or invested in the market. As a result, you’re underinvested and losing the potential growth this deduction can bring.

Contrastingly, Kernel’s funds as unlisted index funds (the fund itself is not listed on a stock exchange), avoid these issues. The tax is deducted at the correct Prescribed Investor Rate (PIR) rate either when selling units in the fund or the following April.

In other words, the money owed in tax can be used by the fund and the investor in the meantime. Distributions paid are higher as they are gross of tax, with the tax paid later and separately.

You can read more in our blog about taxation.

Costs associated with investing can add up and have a significant impact on your potential returns over time.

Brokerage fees

While ETF investors have the benefit of setting which price they want to buy and sell for (if they can find a willing buyer/seller at that price), this comes with higher trading costs than index funds.

The usual brokerage rate in New Zealand for retail investors is somewhere between 0.20% and 1.00% per trade. This is a significant cost, especially if you are wanting to set up a regular investment plan into a fund.

With Kernel’s unlisted index funds, you purchase units directly with no transaction fees. Zero.

Another hidden cost with trading is buy and sell spread costs, which in essence are a fee. This cost reflects the price at which investors can buy ETF units on an exchange and the price at which these units could be sold. It’s how the “market maker” makes their money at a cost to you.

Find out more on buy and sell spreads.

Foreign exchange fees

As an everyday investor, when you buy an international ETF from New Zealand using an investment platform, it’s likely that you are paying a Foreign Exchange (FX) fee when exchanging your money from NZD into USD, or otherwise. This fee probably sits around 0.40% per trade depending on the platform you’re using.

As a fee, it doesn’t sound like a lot but can reduce your investment and returns. There’s a high chance you’re paying much more than what larger professional or institutional investors are paying to exchange their currency. Unless you are invested for many years, the impact of FX fees can often be much greater than the management fee difference (which investors can over-focus or base decisions on).

Comparatively, NZ-based funds that are investing internationally on your behalf handle the effects of foreign exchange within the fund, at an institutional rate. The FX fee mentioned above is included in the fund, saving you the extra cost and hassle of figuring out what your total cost to invest is. For example, on average Kernel pays less than 0.01%, which is covered within the fund.

Dividend drag is the lag between when ETFs receive a dividend payment and when it invests this money.

This is important because the more money that isn’t invested in the share markets at all times, the worst off the investor is. With ETFs,(like the above-mentioned tax)the dividends paid by companies to the fund often sit as cash until it’s distributed to investors (often months later).

Furthermore, a portion of your investment is actually held in cash by the fund to pay back to you as the next distribution. This “drags” the performance of the ETF units vs the actual performance of the index.

Kernel doesn’t do this. We’re able to have equity funds more than 99.9% invested in the companies comprising the index giving the investor the closer return to the index.

All three of these factors contribute to what is known as tracking difference, the difference between the index performance and the fund’s performance. At Kernel we monitor 16 factors that affect tracking difference because lower tracking difference = lower cost.

Any management fees paid to a fund manager eats into potential returns an investor makes.

While managing funds efficiently and to a high standard does have a cost, managing a listed fund does have a higher cost.

Because Kernel’s index funds are unlisted, we are able to avoid extra listing and registry fees that come along with being a fund listed on a stock exchange. Hence, we can keep our management fee lower, and pass on the extra returns to our investors. All the companies we invest in are listed on stock exchanges, so the funds are still very liquid.

ETFs are listed funds and incur the previously mentioned listing and registry fees. This pushes their management fees up. More fees = less returns for investors.

To help paint the picture, let’s use an example. Let’s say Sarah and Alex both have $10,000 to invest in either a Kernel Global index fund, or an ETF listed on the New York Stock Exchange.

Sarah decides to invest $10,000 in an ETF and Alex in the Kernel Global 100 fund, and for comparison ease, let’s assume both track the same index. The key difference here is the investment type (vehicle) they are investing through.

When Sarah invests in an ETF, she must pay brokerage and FX conversion fees. Remembering that hidden tax leakage may occur and that brokerage and FX conversion fees are charged both when buying and selling units in a fund.

On the other hand, Alex who is investing in an index fund through Kernel doesn’t need to pay any brokerage or FX conversion fees, or account for tax leakage.

Suppose that the total return after 1 year of investing in both scenarios is 7% including a 2% dividend. This has been the long-term average. If Sarah invests in an ETF, she will be left with an actual return of 4.68% (after tax and fees). Her initial $10,000 investment will have grown to $10,468. Whereas Alex’s initial investment of $10,000 into the Kernel Global 100 fund will have grown 5.29% to $10,529.

The difference between the actual return of investing in an ETF is also magnified if Sarah and Alex were to have more money invested.

Reworked example based on our new fees

For example, if Sarah had a total of $50,000 invested overseas, the tax is even higher and her actual return would be just 3.68%, half of the index performance.

Meanwhile, regardless of the amount of money invested in Kernel funds her actual return would be 5.29%. The reason being that Kernel has lowered the annual management fees to 0.25% (0.45%) for the ten core funds (three thematic funds) since 4th April 2022. That’s quite the difference over the long term!

*over the time period of one year.

This does not take into account that to exchange the money back to NZD will cost a direct investor about another 1%.

If the investor sold back in New Zealand dollar at the end of the year, they would have only$51,369. A return of just 2.72%, compared to 5.29% for the Kernel fund and 7% for the index (which pays no tax or costs).

As you can see, the impact of tax and fees combined are higher when investing in any internationally listed ETFs compared with a Kernel fund over the time period of one year. While the difference may seem somewhat insignificant, over a longer period of time and as the amount you’re investing increases, this can work out to be significant. Most importantly it is far more than the management fee, even if the US ETF had a management fee of zero.

With Kernel, there are no transaction costs, and all funds are currently in NZD so there are no FX Conversion fees. Read more about Kernel’s fees here.

While management fees are important for both ETFs and index funds, there’s other and hidden costs to investing in different types of investment structures.

At Kernel, we’re focused on the subtleties to maximize returns for you as an investor. Good fund design, coupled with great indices that have proven value over time, will give you a better return. And greater returns are ultimately what every investor is striving for when they invest!