Beyond ETF Expense Ratios

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Since ETF investors can't own indexes directly, the next best thing is to choose a fund that has the smallest tracking error.

Generally, expense ratios are good indicators-all else being equal, smaller management fees usually give investors more returns.

However, holding down costs, even in plain-vanilla ETFs, doesn't necessarily translate into minimizing the difference between fund and index performance.


What can help explain the differences between management fees and tracking error are two things:first, portfolio turnover; and second, securities lending.

Let's tackle portfolio turnover first. During rebalances, some funds are more efficient than others, whether that's due to lower turnovers or better manager skill.

For example, the table below compares three funds that track the S&P MidCap 400 Index:

  • iShares S&P 400 MidCap (NYSEArca:IJH)
  • SPDR S&P MidCap 400 (NYSEArca:MDY)
  • Vanguard S&P Mid-Cap 400 (NYSEArca:IVOO)

IVV vs SPY vs VOO

Last but not least is the question of liquidity. Those who trade frequently are arguably more interested in tradability than holding costs. But the most liquid funds aren't necessarily the ones that track their indexes the most closely. MDY, for example, is by far the worst at tracking the S&P MidCap 400 Index.

Yet it is the most liquid fund in the midcap class. MDY enjoys the highest average daily trading volume-2.5 million shares, or $457 million. In comparison, IVOO-the S&P MidCap 400 ETF with the smallest tracking error-has an average daily volume of 5,000 shares, or $327,000.

Similarly, the large-cap VOO's median performance difference is smaller than those of IJH and MDY. However, it trades in much smaller volumes despite having fairly small bid/ask spreads and premiums/discounts.

In terms of tax efficiency, it is also the winner. Although none of the funds mentioned in this blog has paid cap gains in recent years, VOO is the only ETF with a significant cap loss inventory. This will help it avoid future cap-gains payouts.

It's not a matter of how much you pay, but what you're paying for-and it's definitely not as simple as just looking at expense ratios.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.




This article appears in: Investing , ETFs

Referenced Stocks: IJH , IVV , MDY , SPY , VOO

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