ETF Expense Ratios: More Than Meets the Eye

By Grant Engelbart, CLS Investments

We’ve all got our pet peeves and soap boxes. For most people they have to do with human behavior. But for me, my biggest pet peeve is the constant attention to ETF expense ratios! The fee war has gotten out of control. I’m actually surprised there isn’t a “free” ETF yet (that would make money based on securities lending). But free isn’t really free, and 0.50% isn’t really 0.50% for a variety of reasons we will explore.

Expenses and Performance: First of all, don’t get me wrong – low cost funds are terrific and being able to deliver the broad stock market at fractions of a percent is a remarkable innovation. But it’s not everything, as we’ve written about before here and here. An index fund will be very cheap, but it will be hard pressed to deliver a return above the index. Smart beta and actively managed ETFs are designed to deliver value above and beyond an index. So, if a smart beta multifactor fund has historically added 2% excess returns versus the market, then paying say 0.50% for that ETF versus 0.03% for a broad market is well worth it!

Tracking: Outside of the explicit expense ratios, there are a number of implicit costs. First, is tracking error/volatility. This is a measurement of the ability of an ETF manager to track an index. If an investor buys a cheap (say 0.03%) ETF that’s designed to track the S&P 500, he or she would expect the return to be 0.03% less than the S&P 500. But due to a variety of factors, it’s rarely exactly that amount. Especially in less-efficient markets, tracking differences can be large and are an implicit cost of ownership that’s often overlooked.

Trading: Trading ETFs can be dangerous if done incorrectly. The use of market orders, buying/selling when an ETF is trading at a significant premium/discount, the spread between the price an investor can buy (ask) and sell (bid), and the intraday fluctuations in general affect returns and overall costs. All of these things translate into buying or selling an ETF away from its true index value, which is an implicit drag on performance. Buying an ETF 0.30% above its true index value all of a sudden makes a 0.03% expense ratio turn into 0.33%! Just let CLS trade for you.

So, the next time advisors or investors are faced with deciding between two products based on cost alone, keep the aforementioned factors in mind, and remember there are many elements besides expenses that should be front and center in investment management.

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