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)
,%20MDY%20can%E2%80%99t%20lend%20securities%20the%20way%20a%20fund%20structured%20as%20an%20investment%20company%20can.%20Therefore,%20MDY%20and%20other%20UITs%20have%20to%20rely%20on%20good%20turnover%20management%20to%20maximize%20investor%20returns.%3C/p%3E%0A%3Cp%3EIn%20addition,%20UITs%20can%E2%80%99t%20reinvest%20dividends,%20which%20is%20a%20double-edged%20sword.%20Although%20this%20allows%20cash%20from%20dividends%20to%20provide%20some%20cushion%20in%20down-market%20scenarios,%20it%20also%20keeps%20cash%20sitting%20on%20the%20sidelines%20when%20markets%20do%20go%20up.%3C/p%3E%0A%3Cp%3EAlthough%20MDY%20does%20poorly%20against%20its%20segment%20competitors,%20MDY%E2%80%99s%20large-cap%20counterpart%E2%80%94the%20SPDR%20S&P%20500%20ETF%20(NYSEArca:SPY)%E2%80%94does%20quite%20well%20against%20other%20U.S.%20large-cap%20equity%20funds%20such%20as%20the%20iShares%20S&P%20500%20Index%20Fund%20(NYSEArca:IVV)%20and%20the%20Vanguard%20S&P%20500%20ETF%20(NYSEArca:VOO).%3C/p%3E%0A%3Cp%3E%3Cimg%20src=)
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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