The Foibles of ETF Expense Ratios

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.

SEE MORE: Income-Oriented ETF Portfolios Ripping it up Mid-Year

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.