ETF Trends
ETF Trends

By Grant Engelbart, CFA, CLS Portfolio Manager

ETFs have seen explosive growth, in part due to lower overall costs and with some assistance from active managers underperforming for a number of years.

Now, don’t get me wrong – low fees are great for investors, particularly long term (which most, if not all, investors should be).

However, in some cases, fees have become the only thing analyzed. When, in reality, there are many considerations beyond simply analyzing the stated expense ratio, including tradability and tracking, access, and exposure.

The ability to trade an ETF, and the ability for an ETF to accurately track its underlying index are huge – and often forgotten – elements to ETF investment. Looking at the ETF universe, on an equally-weighted basis the average bid-ask spread is a whopping 0.90%, and on an asset-weighted basis a reasonable 0.07%. Without proper trading, investors could effectively double their expense ratios just by purchasing the product!

Even if a product is cheaper via expense ratio, but trades at a wider spread, investors can experience higher costs than they anticipated. In addition, ETFs track indices and are arbitraged by market participants to maintain their tracking accuracy. Many ETFs track their indices very, very well – yet still fluctuate ever so slightly around the NAV of the index they are tracking. After all, as every disclosure says, you can’t invest directly in an index. Thus, the expectation of experiencing the exact returns of an index less expenses should be taken with a grain of salt.

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But does this really matter? The expense ratio of an index-tracking ETF is different than that of an actively managed mutual fund. First, the fee is obviously significantly lower. However, the expenses in a mutual fund are paid to the manager to outperform an index – something that is difficult to do with a large fee headwind. Mutual fund expenses therefore are often looked at as an additional all-in cost. I would argue that ETF expense ratios should not necessarily be looked at in the same way. The expense ratio of the ETF is the price you pay for access to that index. Consider an investment in the S&P 500.

To mimic the holdings on your own, you would need more than $600,000 to buy all the positions proportionately, and at a standard online broker commission of $10/trade it would cost you over $5,000 in commissions, or 0.80% (not to mention rebalancing costs). Right now, you can purchase an S&P 500 ETF with less than $200 and “pay” an expense ratio of 0.05%. And that is just the S&P 500. Imagine trying to gather several emerging market bonds together in a diversified way – seems like a worthwhile reason to pay a minor fee.

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As the saying goes, “It’s what’s inside that counts,” and that couldn’t be truer with ETFs. The exposure and structure of the ETF is absolutely crucial, and more times than not, these make up for the return difference between similar ETFs, not expenses. It may come as a surprise, but fewer than 6% of all ETFs share the same index, and there are only 11 indexes tracked by more than two ETFs. Some ETFs cap their holdings at different maximum weights.

One ETF may have its largest holding at 25% and another is capped at 15%; that gap can significantly outweigh expense differences. There are also a number of different choices in each space. Consider U.S. large caps – do you want the largest 50 stocks? 100? 200? 350? 500? And the list continues. These additional securities, even if it’s only a few, can make large differences. Many ETFs also lend out their internal holdings to short sellers and generate extra income as a result. Most of the time, this income is paid to the shareholders of the fund and helps to offset expense ratios and tracking differences.

Don’t get me wrong – ETF expense ratios matter, and ETFs have been and will continue to be remarkable innovations. However, instead of nit-picking over a couple basis points, time is better spent analyzing what truly makes the ETF in question unique. Even just a couple of years ago, there was no way to efficiently and cost-effectively allocate to some of the areas of the globe where ETFs provide exposure to.

Grant Engelbart is a Portfolio Manager at CLS Investments, a participant in the ETF Strategist Channel.