Why you should use ETFs in your SIPP

Our ETF editor Tom Bailey names the two key reasons young investors should hold ETFs in a SIPP.

If you are investing money in your self-invested personal pension (SIPP), that means you are invested for the long term. Under current rules, you cannot access money in your SIPP until you are 55 (this will rise to 57 in 2028). For those in their 20s, therefore, that means anything you invest must stay in there for the next 30 years or more. 

Such a long time horizon makes exchange-traded funds (ETFs) perfectly suited to be held in a SIPP. While there are many reasons why you should use ETFs, there are two key benefits that become much more apparent when investing for the long term.

Low costs are a key attraction 

First, costs. Funds charge a fee to administer and run the portfolio. However, ETFs have much lower costs than active funds run by a fund manager. ETFs, being passive, track an index of stocks. This makes them comparatively cheaper to run because there is less manpower involved in the process, which is reflected in the fee investors pay. 

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For example, the average fee for an active fund available to UK investors is about 0.85% per year (called the ongoing charges figure, or OCF). In contrast, the average fee for a passive fund is about 0.23%, but many ETFs tracking big name market indices, such as the FTSE 100 or S&P 500, charge as little as 0.07%. 

Over time, fees compound, creating huge differences in returns between those who opt for funds with low or high charges. For example, say you have £100,000 invested. If that earned 5% every year for the next 30 years, you would end up with about £432,190, according to the Candid Money fund charges impact calculator*.

Of course, in the real world, investors pay fund fees. If you paid 0.85%, the average fee for an active fund, after 30 years your £100,000 pot would be worth £338,671 (based on 5% annualised growth). That means you have effectively paid £93,519 in fees. 

If, however, you were invested in ETFs, and as a result paid an average fee of 0.23%, your £100,000 pot would be worth £404,674 after 30 years of 5% returns. That means you have paid £27,517. The difference between paying 0.85% in fees and 0.23% in fees, therefore, is substantial over a 30-year period. 

*calculations are estimates provided for illustrative purposes only

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However, this does assume that the active fund and the ETF return exactly the same over the 30-year period – 5% annualised growth. Of course, the active fund could outperform the ETF, which would either reduce the fee gap or erode it completely and give investors a bigger sum of money (net of fees). 

But this is the major drawback of picking an active fund: outperformance cannot be guaranteed in advance. Moreover, various academic studies have shown only a small number of actively managed funds consistently add value over the long term.  

An investor can spend the next 20-30 years trying to anticipate the best fund managers. The less risky and easier option might be to invest in a basket of ETFs tracking global stock markets.

Many respected investors have emphasised the importance of focusing on fees. One of the most famous was Jack Bogle, the founder of Vanguard, one of the world’s largest providers of index funds and ETFs today. One of Bogle’s key points was that investors have no control over the performance of their investment – but one thing they can control is the amount they pay to invest. 

All investors should try to minimise their fees – but for the long-term investor in a SIPP, it is paramount due to the ability of these costs to compound. It can result in potentially serious differences in money when the time comes to cash out your SIPP.

Markets tend to rise over the long term

The second key benefit of holding ETFs in a SIPP is that, historically, stock markets go up over long periods of time. 

The US stock market has provided a return of around 10% per year over the past few decades. The average annual return for an index of global equities over the past 100 years has been between 4% and 5%. Looked at each year, those gains might appear small, but over time they compound and add up. And, if you're a younger SIPP investor, you’ve got plenty of time.

Even if the future return of the global stock market was just 4% annualised a year, that would still add up to decent compounded growth over the next 30 years. For example, assuming 4% annualised returns over 30 years, you could turn £10,000 into £32,434. If you add in £100 per month contribution over the same period, that 4% annualised growth turns into £101,185. 

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The long time horizon also allows investors to ride out the usual ups and downs of the market. ETFs are perfectly suited to buy and hold, as investors are receiving instant diversification, first by the holdings tracked within the ETF, and also perhaps by using an ETF focused on an area of the market that is difficult to gain exposure to. 

For example, take the 2008 global financial crisis. With the full extent of the crisis becoming clear in 2008, the main UK index ended the year down 31.3%. Ouch! But anyone with a FTSE 100 ETF who simply stayed invested would have started to experience recovery from around March 2009. By 2013 they would have been back to the price levels since before the crash. Had they continued to invest regularly in their ETF while the market was lower, their performance would have been even stronger. 

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Overall, returns were better in the US market, but any investor with a basket of ETFs tracking global stocks would have benefitted significantly from this.

There are some exceptions – those who invested in Japan at the peak of the bubble in 1989 would still be underwater. Likewise, those who bought stocks in China or Russia faced wipe-outs after each of their revolutions. But these are the exceptions and are exceedingly rare. And you can mitigate this country-specific risk by diversifying with a truly global ETF.