Exchange Traded Funds (ETFs) are investment funds traded on stock exchanges, much like stocks. As most of you know, an ETF holds assets such as stocks, commodities, or bonds and generally tracks an index, such as a stock or bond index. Their attraction stems from their stock-like features, tax efficiency and low costs.
I’m a fan of ETFs, but only up to a point. I’m also a natural skeptic (it’s part of my job description as an advisor) and when an investment comes along with a low cost story attached to it, my first instinct is to start digging.
Recently, I came across two fascinating deconstructions of the true cost of ETF investing:
- The Total Cost of ETF Ownership1 – An Important But Complex Calculation (FlexShares, the ETF unit of Norther Trust).
- ETFs: The Real Story on Total Cost of Ownership2, by Jim Ross, Executive Vice President, Chairman, Global SPDR Business, part of State Street Global Advisors.
Get ready for a surprise.
Explicit, implicit and opportunity costs
According to FlexShares: ‘The many different cost considerations when purchasing an ETF can be segmented into three basic categories: explicit costs, implicit costs and opportunity costs. It is important to understand that these costs are not independent of one another; sometimes lowering an explicit cost can increase implicit costs or even reduce the effectiveness of the investment strategy.’
Look at it like this. To calculate the total cost of ETF ownership, simply combine explicit, implicit, and opportunity costs. Explicit costs (this is the easy part) include an ETF’s management fee, custody costs, acquired fund fee, bid/ask spread and trading commissions. Implicit costs are more difficult to assess, and include what’s known as an ETF’s tracking error, portfolio turnover, and capital gains. Opportunity costs are the least tangible of all, since they depend on a judgment call about the profit or value of something that must be given up to acquire or achieve something else.
An expense ratio doesn’t capture the full cost story
As Mr. Ross observes in his penetrating article: ‘It’s not surprising that in today’s low-growth environment, expenses are top of mind. Many investors focus on a fund’s expense ratio to determine if it is low cost. But the expense ratio captures just one important part of the total cost of ownership equation. While expense ratio is an important part of the equation, it is essential to evaluate other costs associated with an ETF investment.’
Take a look at the graphic below, sourced from State Street Global Advisors:
Deconstructing the variables
As you can see, there are three variables that make up the cost of owning an ETF.
Expense Ratio. This is the portion of your investment that the fund charges annually. Low expense ratios are good news basis for investors and they are what drive the broad attraction of ETFs.
Commission. As Mr. Ross writes, ‘Trading commissions, like expense ratios, have also compressed over time due to competitive forces. Some wealth management platforms now offer certain ETFs to trade for free. But a high expense ratio or a wide bid/ask spread can cost you more than what you would save on commissions over the life of your investment.’
Spread. The bid/ask spread (spread for short) is the difference between the price a buyer is willing to pay for a share and the price a seller will sell it for.
The best ETF for you depends, in part at least, upon how long you plan to hold it. If you expect to trade frequently, execution costs —like spreads and commissions—assume a key cost-related role. But if you are adopting a buy-and-hold ETF strategy, execution costs don’t matter nearly as much.
Consider a discussion with me
ETFs are an attractive option for the do-it-yourself investor. Superficially, that is. But if you really want the bottom line skinny on them, consider talking to me. It’s very easy to select an ETF that ends up being way more costly than you expect. Result? The investment can significantly undermine a portfolio’s total return.
Geoff Funke, Senior Wealth Advisor, Scotia Wealth Management, 604.535.4721.