facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast blog search brokercheck brokercheck

The Total Cost of ETF Ownership: Investment Considerations Beyond Expense Ratio

Exchange-traded funds (ETF's) have upended the investment landscape since the first one was launched in 1993.  Since then, the ETF universe has grown at an exponential rate to where there are now more than 2,000 of them accounting for trillions of dollars in assets.  They continue to steal market share from traditional mutual funds for three main reasons: (1) lower fund management expenses, (2) tax-efficiency, and (3) intraday liquidity.

It's really the first of these factors, low mutual fund management expenses, that is grabbing the most attention from individual investors and advisers alike.  Market participants are awakening to the fact that expense ratio is a key determinant of future fund performance.  And ETF sponsors - the companies responsible for designing, marketing, distributing and managing these vehicles - are acutely aware that a fund's expense ratio can mean the difference between a successful product launch and the creation of an ETF zombie.

For this reason, ETF sponsors have recently been taking this focus to an extreme bordering on silliness.  Last year, Social Finance Inc. launched a couple of ETF's in which the fund management fees were being waived. Going one better, Salt Funds then introduced its Low truBeta U.S. Market ETF, in which investors were being paid 50 cents for every $1,000 invested in the fund, in effect a negative .05% expense ratio.

Not to be outdone in this race to attract investors with a misguided overemphasis on low costs, brokers continued to expand their commission-free ETF lineups.  TD Ameritrade, Schwab, Vanguard, and Fidelity all initially offered free trading on more than 500 ETF's, and then of course supplanted that with commission-free trading across the board.

There's no doubt that lower fund management expenses and lower transaction fees are beneficial to investors - all other things being equal.  But that's the rub.  There are several other cost considerations in choosing which ETF to buy, and when to buy it, that can easily outweigh whether you pay or receive 50 cents per $1,000 invested per year, or whether you pay your broker nothing or $7 per trade.

ETF Management Fee Stability

An initial consideration in purchasing an ETF, and in particular one with a current expense ratio that sounds too good to be true from one of the less-established ETF sponsors (like a Social Finance or a Salt Funds), is whether those low management fees are sustainable.  In the case of these two sponsors, the funds' stated fees were merely being waived temporarily.  The management expenses of .19% on SoFi's ETF's were to be reinstated as soon as June, and the management expense of .29% on the Salt ETF was to be imposed even sooner.

It may occur to some investors to take advantage of these bargains while they exist, and then to swap out of these funds if and when their management expenses increase.  Like most financial products with teaser rates, however, there may be switching costs to incur.  Getting out of an ETF may become expensive if its liquidity fades, and even if not, investors may still realize capital gains taxes in swapping from one ETF to another.

The lesson here, then, is that an ETF sponsor's history of holding the line on (and even lowering) fund management expenses through time may be a more important consideration than a given ETF's current expense ratio.

ETF Sustainability

According to Bloomberg, 58 ETF's were liquidated in the first half of last year, making it the industry’s worst-ever start by this measure.  And this was during a very good period for returns in both the stock and bond markets, during which investors were on the whole throwing money at the mutual fund industry.

The mortality rate within the ETF universe merits serious consideration among investors, since ETF closures can result in a number of negative consequences.  I've written previously about the ETF liquidation process and the problems it can present to a fundholder in an Articles on Wealth Management Topics blog post entitled "Beware of Exchange-Traded Fund (ETF) Closures".  Suffice it to say that a prospective ETF's ability to survive over the long-term may easily outweigh its expense ratio as an investment consideration.

Consider as a case study the ETF Industry Exposure & Financial Services ETF - the first ETF to explicitly track companies in the ETF industry - which (in a cruel twist of irony for its investors) ceased trading last year.  A couple of lessons from this episode for investors attempting to discern a fund's sustainability:

(1) An ETF with a seemingly promising investment focus won't necessarily generate sufficient returns or attract enough investment assets to survive.  This fund dramatically underperformed the S&P 500 during its last year of existence and only had about $6 million in assets when its sponsor threw in the towel, even though the ETF industry itself is growing by leaps and bounds.

(2) An ETF's sponsor, regardless of who it is, will be fairly merciless in terminating a fund incapable of attracting and maintaining sufficient investment assets.  This ETF lasted barely more than two years from launch to liquidation.  And Blackrock, the biggest ETF sponsor, has closed dozens of funds through the years.

ETF Trading Liquidity

As mentioned above, most discount brokers now offer you the ability to trade hundreds of ETF's without paying a commission.  However, even a commission-free ETF may have another, less apparent, form of trading cost: the bid/ask spread.

When you transact in index funds or actively managed mutual funds, the price at which you buy and sell, i.e. the fund's net asset value, is the same and will be determined after the market's next close.  By contrast, one of the benefits of ETF's is that you can buy and sell them throughout the trading day at a price you know with fairly good accuracy before you place the order.

However, the price at which you will buy an ETF will be the "ask", the lowest price a seller is willing to accept. And the price at which you will sell an ETF will be the "bid", the highest price a buyer is willing to pay.  The difference between these two prices is known as the bid/ask spread, and the lower it is the better because this form of trading cost can be a significant part of an ETF's overall cost of ownership.

Generally, very well-established funds with lots of assets under management and trading liquidity will have very tight, close to negligible, bid/ask spreads.  However, according to ETF.com, the average bid/ask spread on ETF's listed on U.S. exchanges is .48%, and the median spread is .20%.  Moreover, an ETF's bid/ask spread can change through time, e.g. can widen if the fund starts to lose investment assets.

In this respect, an ETF's trading liquidity, as reflected in its current and future bid/ask spread, is an important factor to consider.  And this is especially the case if you expect to be buying and selling the fund frequently.

ETF Premiums and Discounts

The vast majority of exchange-traded funds are passively managed.  That is, they are designed to track the performance of an investment index like the S&P 500 Index or the Barclays Capital U.S. Aggregate Bond Index. However, depending on the liquidity of the assets within an ETF's index, on financial market conditions in general, and on a number of other factors, the market value of a given ETF may deviate from its intrinsic value, its net asset value (NAV).

An ETF may trade above, or "at a premium" to its NAV, or it may trade below, or "at a discount" to it.  In general, arbitrageurs will keep these anomalies to a minimum, but they do tend to crop up during periods of market stress. In any event, buying an ETF at a premium or selling one at a discount will tend to add to an ETF's total cost of ownership.

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.

Contact Paul