The Foibles of ETF Expense Ratios

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.