By
Morningstar
:
By Patricia Oey
Last month, my colleague Abraham Bailin wrote an article titled
"The Intangible Costs of ETF Ownership,"
which explained the concept behind Morningstar's proprietary cost
data points. (The data points can be found under the Performance
tab.) In this article, we will discuss how to use these data points
when comparing funds within a category.
First, a quick review of the data points and their definitions.
Estimated holding cost
reflects how much a fund's NAV has lagged its index over the last
year. This can be considered the fund's "cost" to replicate its
underlying index. The largest component of this figure is usually
the fund's expense ratio, but other contributors may include high
turnover (which drives higher trading expenses), higher expenses
due to exposure to less-liquid securities (such as small caps or
high-yield bonds), sampling (which can result in positive or
negative alpha), and share lending (which is a source of revenue
and therefore offsets other costs). EHCs are calculated as the
geometric difference between the index return and the fund return
over the past year.
Tracking volatility
measures the volatility of a fund's net asset value performance
versus its benchmark index. This is measured as the standard error
of the regression of the NAV's performance versus that of the
index. The lower, the better. A potential driver for higher
tracking volatility is large flows in and out of the fund as a
percent of total assets under management. For example, during
creations and redemptions, baskets with adjustment for dividends
can be off, which can drive tracking volatility. For
exchange-traded funds with negative EHCs, investors can check the
tracking volatility figure--if the tracking volatility is high,
then the negative EHC may be attributable to sampling, and it is
unlikely that the fund will be able to consistently outperform its
index.
(click to enlarge)
U.S. Equities
ETFs in the large-cap categories have estimated holding costs
nearly in line with their expense ratios given the liquidity of the
underlying holdings. ETFs with significantly higher EHCs relative
to their expense ratios tend to be funds that track broader indexes
that include small caps (which can be less liquid) or funds that
track fundamental indexes, which tend to have higher turnover. Not
surprisingly, small-cap ETFs have EHCs that are higher than their
expense ratios, relative to large caps. Overall, the ETFs with the
largest assets under management (which covers different size and
style categories) have the lowest EHCs and tracking volatility--in
other words, these ETFs are incredibly efficient.
(click to enlarge)
International Equities
For international-equity ETFs, it is not surprising to see many
more funds with high tracking volatility (combined with negative
EHCs)--this is consistent with the fact that many foreign equity
ETFs use representative sampling. There is also another reason for
this--Vanguard, as well as some of the smaller ETF providers,
employs fair value pricing. Vanguard MSCI Emerging Markets ETF(
VWO
) and iShares MSCI Emerging Markets Index(
EEM
) track the same index, but the former had a tracking volatility of
5.81 whereas the latter had 1.21. The reason for this discrepancy
is because Vanguard employs fair value pricing to its NAV whereas
iShares does not. Mutual funds that invest in foreign securities
are required by the SEC to employ fair value pricing, and, because
Vanguard ETFs are a share class of their corresponding mutual fund,
Vanguard ETF NAVs have to be fair valued. (Mutual funds price their
NAVs after the U.S. market close and will apply fair value pricing
to their foreign securities holdings whose prices at that time are
"stale.") Because ETFs trade during U.S. market hours, it can be
argued that the ETF's price is the fair value, and iShares cites
this as the reason why it doesn't fair value its ETFs' NAVs.
If the only difference between EEM and VWO was that the former
did not employ fair value pricing and the latter did (and assuming
that both employed full replication and charged the same expense
ratio), we would expect EEM's market price to show greater premiums
and discounts relative to its NAV and that its NAV would closely
track its underlying index, whereas we would expect VWO's market
price to show lower premiums and discounts relative to its NAV and
that its NAV would not track its index as well as EEM. But more
important, we would expect the price performance of EEM and VWO to
be essentially the same, which is important for investors because
they buy and sell at market prices and not at NAVs. While EEM has
been able to incur a lower EHC relative to its expense ratio, or
ER, over the last year, it is not guaranteed that the fund managers
will be able to continue to provide this small amount of alpha.
Given VWO's significantly lower ER (which is a much more stable
figure than EHC), we prefer it over EEM.
(click to enlarge)
Fixed Income
For fixed-income ETFs, another cost that is reflected in the EHC is
the positive or negative alpha from the cash component of the
creation basket. Because many fixed-income securities are not very
liquid, some fund providers allow authorized participants to submit
creation baskets with a cash component in lieu of certain
securities. The fund company then uses the cash to purchases
securities to complete the basket.
SPDR Barclays Capital High Yield Bond(
JNK
) and iShares iBoxx $ High Yield Corporate Bond(
HYG
) provide fairly similar exposure, however, JNK's EHC has been
significantly higher than that of HYG for the year to date. SPDRs
allows for more cash in its creation baskets, relative to iShares,
and it is possible that SPDRs has not been able to efficiently put
that cash to work over the past few months, as there has been
strong demand for this relatively illiquid asset class, which
results in wider bid-ask spreads. Fixed-income ETF NAVs are based
on the bid prices of their underlying securities, but in practice,
the actual purchase price can be much higher, especially during
periods of illiquidity. If a fund company takes a creation basket
that is part cash, higher bid-ask spreads for the underlying
holdings will drag on the fund's NAV (this can be observed as the
gap in performance between JNK's index and NAV, which is greater
than that of HYG). In comparison, the iShares product takes
creation baskets with less cash, so the additional cost of wider
bid-ask spreads on high-yield bonds is reflected in higher
market-price premiums to NAV. It is possible for fund managers who
take creation baskets with a cash portion to provide positive
alpha, but we note that for JNK, that was likely not the case--over
the past three years, JNK's NAV has trailed that of its index by
184 basis points, annualized, while HYG trailed its index by 25
basis points. Based on this information, we would prefer HYG over
JNK.
Another example of the intricacies of fixed-income ETFs with
illiquid underlying components can be found in Timothy Strauts'
article,
"We Love This ETF: Sell It Now."
(click to enlarge)
Vanguard also employs fair value pricing for its fixed-income
ETFs (as fixed-income markets close one hour prior to equity
markets), which can contribute to higher tracking volatility for
its funds but should not negatively impact long-term performance.
Below, we highlight again that despite Vanguard Total Bond Market
ETF's(
BND
) high tracking volatility, its price performance relative to its
underlying index has been almost in line with that of iShares
Barclays Aggregate Bond(AGG) (these two ETFs track very similar
indexes).
(click to enlarge)
Exchange-Traded Notes
Generally speaking, international-equity ETFs and fixed-income ETFs
incur higher costs because the underlying assets are more expensive
to gain access to, relative to U.S.-equity ETFs, and not because
they are faulty products. Other vehicles, such as open-end mutual
funds, also face similar costs. Exchange-traded notes, however, are
a different story.
ETNs are uncollaterized notes issued by banks that promise to
provide the returns of the stated underlying index (sometimes
advertised as offering
perfect tracking
), less fees. These banks use derivatives and certain strategies to
hedge its position and deliver returns. As such, we would expect an
ETN's EHC to be in line with its expense ratio. This is not the
case, as the weighted average of the group's EHC minus the expense
ratio of 0.17 is the highest among the four categories. This
reflects the fact that some ETNs have additional and sometimes
opaque fees, such as brokerage expenses, financing fees, and
path-dependent fees. In fact, an investor can use an ETN's EHC to
determine if an ETN has additional fees, which are usually not
explicit in the note's fact sheet and other marketing materials.
More details about the risks of ETNs can be found in my colleague
Samuel Lee's article,
"Exchange-Traded Notes Are Worse Than You
Think."
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
ETF Investing In Europe: Finding The Right
Strategy
on seekingalpha.com