In the last few years, investors have flocked to exchange traded funds for many reasons, low costs being one of them.
However, those costs aren’t quite as low as they used to be—or are they?
From December 31, 2005, to March 31, 2012, the market’s average ETF expense ratio increased from 0.39% to 0.56%.* For investors, that represents a cost increase of $17 per year for every $10,000 invested. That’s a relatively small amount, but one that could add up considerably over time—particularly for investors with large portfolios.
Also of potential concern to investors is the fact that the average “bid-ask spread” (the difference between the offer and the sale price, essentially representing the market maker’s profit) for ETFs has been expanding as well—a cost that is sometimes overlooked. The average spread on ETF products has nearly doubled since the end of 2005 (the first year ETF spreads were available in the aggregate), from 0.16% to 0.31%.**
So, are ETFs not the bargain they once were?
Well, it turns out that there’s more to those cost “averages” than meets the eye.
“We’ve found that when you take a closer look at the data, the averages are misleading because most of the money is flowing into lower-cost ETFs,” said Joel Dickson, a principal and senior investment strategist in the Vanguard Investment Strategy Group. “It’s sort of the reverse of the ‘Lake Wobegon’ effect. In this case, most investor dollars are below average in terms of the costs they are paying.”
Mr. Dickson’s point is borne out by reviewing “asset-weighted” averages, where the largest ETFs carry more weight than smaller ones, providing a truer picture of the costs investors are paying.
The asset-weighted average expense ratio for ETFs is 0.32%—significantly less than the simple average of 0.56%.* Similarly, the asset-weighted average spread is a negligible 0.04%—a far cry from the 0.31% industry figure.**
“Investors are voting with their dollars by selecting the products that offer the lowest costs,” Mr. Dickson said.
As for why industrywide cost averages for ETFs have been creeping up, Mr. Dickson explained that the number of narrowly focused, niche ETFs has proliferated in recent years. These less liquid ETFs carry higher costs that push up industry averages. But they tend to be smaller in size, so they have less impact on the asset-weighted figures.
For more information about the relationship between cash flow and costs, read Costs matter: Investors are still voting with their feet.
*Sources: Vanguard analysis of data provided by Bloomberg and Morningstar Direct, as of March 31, 2012.
**Sources: Vanguard analysis of data provided by Bloomberg and ArcaVision, as of March 31, 2012.
Notes:
- Vanguard ETF Shares are not redeemable with the issuing fund other than in creation unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
- All ETF products are subject to risk, which may result in the loss of principal.
- Past performance is not a guarantee of future results.