The total cost of owning an exchange-traded fund (ETF) can be roughly split into two parts: holding costs and transaction costs. Holding costs come with owning an ETF. Trading costs are paid as investors buy and sell.
Total Cost of Ownership = Holding Costs + Transaction Costs
Holding costs include fees and various other factors that affect an ETF’s performance. Transaction costs can have an impact on the effective price paid for buying or selling an ETF. How important these two costs are relative to each other depends on an investor’s time horizon and the amount of money invested. For investors with long time horizons, holding costs matter more than transaction costs. The opposite is true for investors with short time horizons.
ETF holding costs
Investment fee
An ETF’s investment fee is the most obvious holding cost for an ETF investor. It’s taken as a percentage of an investor’s stake in an ETF. An investor with a $10,000 stake in an ETF charging 1% would pay $100 in fees paid per year. However, you won’t see this charge on your brokerage account. It is automatically taken from your ETF as part of the unit price. This makes it hard for investors to know how detrimental fees actually are to their total return. Investors should prefer low-fee products to high-fee products, as the growth of $10,000 chart below illustrates.
Sampling
Sampling is a method index fund managers like Vanguard, iShares, or State Street use to closely track their indexes. These firms (and numerous others) will selectively sample securities from their target indexes to achieve representative exposure. This means that even if an ETF holds fewer stocks or bonds than its index, both should look basically the same. The more a fund’s portfolio is sampled, the more likely its performance will diverge from the index it follows. This could lead to an unintended drag on performance.
Turnover
Turnover measures the percentage of a portfolio that is different from year to year. ETFs cycle through stocks or bonds each year at different rates depending on their investment strategies. ETFs with a high turnover ratio (expressed as a percentage) may incur higher transaction costs as they buy and sell portfolio securities than ETFs with a lower turnover ratio. ETF managers are generally good at managing transaction costs, but high turnover can add up and erode returns. Adding to this are the capital gains implications. Part of deciding between investing in ETFs and individual securities is knowing that you are relinquishing control of which assets are sold and bought, and the frequency in which it is done. Selling does not just cause the transaction costs to rack up, but also means that there are tax consequences that are passed down to the investor. This can be a shock at tax time for some ETF investors.
Dividends
Income that you receive from ETFs are referred to as ‘distributions’. Distributions are your share of income from the assets held within the ETF. For example, if the ETF holds stocks and cash, your distributions would include dividends and interest payments. Equity-based ETFs are the most popularly held in Australia. Dividends of stocks held in ETFs can affect the return an investor receives from a fund. The impact those dividends have on performance comes down to factors including investment area. Managers of ETFs that invest in international markets must deal with a labyrinth of tax rules for the countries the stocks they hold inhabit. These tax rules may be favourable or unfavourable to the investor.
Securities lending
Securities lending is one of the rare chances ETF managers have to offset some of an ETF’s cost for investors. They do this by lending out portfolio securities and making a small profit from the transactions. That profit helps offset an ETF’s fee. The practice is low-risk for both the ETF issuer and investors, but investors should note that the ETFs with the highest securities-lending returns are usually some of the riskiest. You can find whether the ETF partakes in this practice through the Product Disclosure Statement (PDS).
How to measure ETF holding costs
The five types of holding costs create a gap between the performance of an index-tracking ETF and its benchmark. Tracking difference and tracking error are two common measures of this rift.
For active ETFs, holding costs are still present, but their influence on performance can be more difficult to quantify. High fees are more prevalent among this group, but history still supports low-cost active ETFs having the upper hand.
Tracking difference
All else equal, index ETFs should produce returns that lag their benchmarks by an amount equal to their annual fees. For example, assume an investor owns an ETF that tracks the ASX 200 and charges an expense ratio of 0.25%. If the ASX 200 rises 10% in a year, the investor’s return, after fees, would be 9.75%:
Tracking Difference = ETF Return - Benchmark Index Return
Fees are the most predictable and readily quantifiable source of the tracking difference between ETFs and their reference indexes.
Tracking error
It’s important to distinguish between tracking difference and tracking error. Tracking difference is simply the difference between an ETF’s return and that of its benchmark during a given period. Tracking error measures the standard deviation of the difference between an ETF’s return and its benchmark’s return over time.
ETF transaction costs
Commission
Commission is the most obvious transaction cost an investor faces when buying or selling an ETF. However, most investors will avoid this cost because many brokerages and online trading platforms charge investors little to nothing to buy or sell an ETF. Low- or no-cost brokerages like Superhero and Pearler have all but removed commissions from the ETF cost equation.
Bid-Ask/Buy-Sell spread
Bid-ask or buy-sell spread is the difference between the share price at which a market maker is willing to buy an ETF (the bid) and the price they’re willing to sell it (the ask). Buyers and sellers pay to cross this spread. While typically small, spreads tend to be wider for certain types of strategies. The wider the spread, the greater the cost to an investor. If buying or selling ETFs frequently, or in large quantities, costs can add up quickly.
Market impact
Market impact is how much a trade might move the market. Smaller investors don’t have to worry about this, but it can be a major consideration for institutional investors. A big trade in a small ETF may move the ETF’s share price against the investor. For example, a large buyer might eat through offers at multiple price levels, pushing up the price paid and essentially creating a transaction cost.
The cost of ETF ownership: The bottom line
The total cost of owning an ETF is typically most sensitive to an ETF’s fees and the investor’s time horizon. Transaction costs matter far more than holding costs for short holding periods, while holding costs matter more for longer holding periods. Over time, the total cost of ownership will often converge with an ETF’s annual fee, so long-term investors should pay close attention to the annual fees of the ETFs in their portfolios.
