One of the biggest reasons exchange funds are steadily pilfering assets from actively managed mutual funds is cost and data suggest massive inflows to cost-efficient funds is helping drive fees lower.
“The asset-weighted expense ratio across all funds was 0.64% in 2014, down from 0.65% in 2013 and 0.76% five years ago,” according to the Morningstar study, Investors Are Driving Expense Ratios Down.
That says advisors and investors are aware of the erosive effects high fees on portfolio returns, particularly over the long-term. However, more goes into an investor’s total cost of ETF ownership than the annual expense ratio he or she sees on an issuer’s web site.
In a recent white paper on the topic entitled The Total Cost of ETF Ownership: An Important – but Complex – Calculation, FlexShares, the ETF unit of Norther Trust (NasdaqGS: NTRS), explores the total cost of ownership concept.
“The many different cost considerations when purchasing an ETF can be segmented into three basic categories: explicit costs, implicit costs and opportunity costs. It is important to understand that these costs are not independent of one another; sometimes lowering an explicit cost can increase implicit costs or even reduce the effectiveness of the investment strategy,” according to FlexShares. [Investors get a Good Deal With ETFs]
To arrive at total cost of ownership, explicit costs, implicit costs and opportunity costs are combined. Explicit costs are easily defined and include and ETF’s management fee, custody costs, acquired fund fee, bid/ask spread and trading commissions. Implicit costs, which are not as readily apparent as their explicit counterparts, include an ETF’s tracking error, portfolio turnover and capital gains, according to FlexShares.
In the ETF space, low fees have played a pivotal role in the ascent of Vanguard and Charles Schwab (NYSE: SCHW), among others. Pennsylvania-based Vanguard, which has knack for lowering fees on its ETFs as they accumulate more assets, has become the second-largest U.S. ETF issuer due in large part to its reputation as a low-cost leader. [More Fee Cuts from Vanguard]
However, there are examples of pricier ETFs outpacing lower cost rivals. Take the example of the FlexShares Quality Dividend Index Fund (NYSEArca: QDF), an ETF that has explicit costs including an annual fee of 0.37%.
“QDF’s expense ratio comes in at slightly below the peer average while the spread associated with buying and selling QDF is five bps above the group’s average. By combining the spread and expense ratio costs, it can be determined that owning QDF over a one-year holding period will be three bps more expensive than the average dividend ETF. Assuming constant spreads and expense ratios over a longer time frame, however, QDF will be the same or slightly less expensive than the category average over a three year or longer holding period,” said FlexShares.
The investors focusing solely on explicit costs might be apt to choose the Vanguard Dividend Appreciation ETF (NYSEArca: VIG) over QDF on the basis of VIG’s 0.1% annual fee, which makes it less expensive than 90% of rival funds.