Exchange traded fund providers have been slashing fees to dirt cheap levels. While cheap investments are an attractive draw, people should not solely invest in a fund based on low expense ratios.
Last month, BlackRock’s iShares reduced the fees on a number of its products, with the Shares Core S&P Total US Stock Market ETF (NYSEArca: ITOT) showing an expense ratio of 0.03%. ITOT was the cheapest on the block for a brief moment. [The New Cheapest ETF In The U.S. Is A Familiar Face]
Not to be outdone, Charles Schwab lowered fees by one basis point on four of its large-cap ETFs in response, with the Schwab U.S. Large-Cap ETF (NYSEArca: SCHX) and Schwab U.S. Broad Market ETF (NYSEArca: SCHB) both coming in at a low 0.03% expense ratio. [Schwab Responds to iShares Fee Cuts]
The cheap expense ratios are great for investors but fees should not solely dictate investment decisions.
“I’m glad fees are coming down, but I maintain that a 2-basis-point fee difference is a lousy way to pick a fund,” Paul Britt, senior analyst at FactSet Research Systems, told Eric Rosenbaum for CNBC.
The cost of ETF investing is more than just a couple of basis points in the expense ratio. While low expense ratios are nice for keeping costs down in long-term buy-and-hold investments, investors should also consider other implicit costs. [How to Pick ETFs as Fee War Heats Up]
For instance, investors should consider tracking error, or how much an ETF’s return may diverge from the underlying benchmark index. A number of factors may contribute to the tracking divergence, including the wide market bid/ask spreads, portfolio optimization, internal trading costs, portfolio management styles and securities lending fees. These factors would help contribute to an ETF’s price divergence from its net asset value.
ITOT, for example, shows a -0.13% maximum downside tracking error over a 12-month period and a median tracking error of -0.08%. Meanwhile, SCHX has a maximum downside tracking error of -0.03% and a median of 0.02%. While ITOT and SCHX may both have a 0.03% expense ratio, the iShares offering has exhibited greater tracking errors.
Along with implicit costs to trades, investors should also know what kind of market exposure they are comfortable with. Since no two ETFs are exactly the same, two similar sounding ETF strategies will hold different weights to company stocks and market sectors.
“Fees are part of the equation, but many long-term ETF investors often consider the index, performance and tax efficiency of their ETF investments,” a BlackRock spokeswoman told CNBC.
For instance, effective December 18, 2015, ITOT will track the new S&P Total Market Index. The S&P Total Market Index includes greater small- and micro-cap exposure and will cover more than double the component holdings of the fund’s current benchmark, the S&P Composite 1500 Index. Consequently, due to its broader market exposure, the new benchmark may be slightly less top heavy.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.