The total cost of owning an ETF may vary widely on a fund-by-fund and investor-by-investor basis.
A version of this article was published in the February 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Exchange-traded funds have become the investment wrapper of choice for a growing number of investors ranging from institutions to individuals. Transparency, tradability, tax efficiency, and low costs are the trademarks of the ETF package. Fees in particular are a critical input in investors' ETF selection process. But when it comes to choosing an ETF--particularly when picking among funds tracking identical or substantially similar benchmarks--it's important to look beyond the headline fee and take a more holistic approach to assessing the total cost of ETF ownership. Here I will outline the components of the total cost of owning an ETF, address how to size them, and discuss how their relative importance varies depending on an investor's circumstances.
The total cost of ETF ownership can be roughly split into two parts: holding costs and transaction costs.
Total Cost of Ownership = Holding Costs + Transaction Costs
The relative importance of the two will vary depending chiefly on an investor's time horizon and the amount of money he is looking to invest. Holding costs include fees and a variety of other factors that affect ETFs' benchmark-relative, or tracking performance. Transaction costs include commissions, bid-ask spreads, and market impact.
In general, holding costs will represent the largest component of the total cost of ownership for long-term investors in an ETF, as they are by definition incurred throughout the holding period. Transaction costs will matter more to investors who have shorter time horizons, particularly in cases where they are looking to invest large sums of money.
Fees are typically the largest component of the cost of holding an ETF. They are also the most readily available and stable piece of a fund's all-in holding costs. But there are implicit costs to account for, too. These costs stem from a variety of factors.
The manner in which funds seek to replicate their benchmarks can also be a substantial source of implicit holding costs. For instance, a fund tracking a benchmark that contains a number of smaller, less-liquid components like an emerging-markets or fixed-income fund may use "sampling" techniques to replicate the returns of its index. Sampling involves investing in a select basket of only the largest, most-liquid components of the benchmark index in an effort to improve the overall liquidity of the fund itself (it makes the creation and redemption process simpler and cheaper for market makers) and to minimize costs. While sampling has some obvious advantages, by virtue of excluding some smaller, less-liquid components of a fund's reference index, it creates another potential source of tracking difference as the fund strays from perfectly mirroring its benchmark. A useful case study that demonstrates the potential for sampling to create tracking issues is iShares MSCI Emerging Markets EEM. Prior to 2010, this fund would hold only about half of the stocks in its index in order to facilitate efficient trading. For this reason, as well as the fund's relatively high expense ratio, the ETF's calendar-year 2009 net asset value return trailed its benchmark's return by nearly 10 percentage points. At the time, Vanguard's emerging-markets stock ETF also tracked the MSCI Emerging Markets Index (it has since changed indexes). In contrast to the iShares fund, the Vanguard ETF was employing a full-replication approach. In 2009, its total NAV return lagged the return of the MSCI Emerging Markets Index by just a bit more than 2 percentage points.