FocusShares' Misplaced Focus

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Offering low costs is a badge of honor that many funds wear proudly, with issuers cutting costs in an effort to be considered the cheapest funds in their respective market segments.

It was with this in mind that on March 30, 2011, FocusShares brought to market 15 ETFs targeting sector and style segments of the U.S. equity markets. Many funds undercut the low-cost leading funds from Schwab and Vanguard.

Despite the low cost and providing solid broad-based representation of their target markets, the funds failed to gain much traction with investors, and after less than 18 months in the marketplace, FocusShares is liquidating all 15 funds by Aug. 30, 2012.

If costs matter so much, what went wrong?

Total costs matter, of which management fees are only a small part. Tracking error and trading costs play crucial and often bigger roles in determining the costs of buying and holding a fund.

This is best expressed in plain-vanilla market-cap-selected and -weighted large-cap U.S. equity funds.

Investors have five options charging less than 10 basis points in management fees:the Vanguard S&P 500 (NYSEArca:VOO), the Focus Morningstar Large Cap (NYSEArca:FLG), the Schwab U.S. Large-Cap (NYSEArca:SCHX), the iShares S&P 500 (NYSEArca:IVV) and the SPDR S&P 500 (NYSEArca:SPY). At the time of its launch, FLG was the cheapest, at 5 bps, but VOO has since reduced its fee from 6 bps to 5 bps to match its competitor.

While management fees set the baseline for cost expectation, the fund's tracking error (as measured by annualizing the daily performance differences between fund and index returns) is the real cost of holding the fund.

With no tracking error, the fund should underperform its benchmark by exactly the expense ratio. Surprisingly, since FocusShares' launch, all five funds have actually performed better than their expense ratios would suggest, likely due to securities lending and astute management. Still, less than 6 bps separates the most and least expensive funds.

As it turns out, trading costs really separate the wheat from the chaff. While SPY, IVV and VOO trade at pennywide spreads with enough volume to satisfy most order sizes, FLG trades less than $70,000 on most days, with average spreads of 0.26 percent.

Ticker

Expense Ratio

Tracking Error

Spread

VOO

0.05%

-0.022%

0.02%

FLG

0.05%

-0.042%

0.26%

SCHX

0.08%

-0.077%

0.04%

IVV

0.09%

-0.058%

0.01%

SPY

0.09%

-0.081%

0.01%

And that's the rub, even though FLG may be cheaper than its competitors, the 3 to 4 bps gained from management cost-savings on an annual basis mean nothing when it costs six times that to switch funds (and that's before commissions).

In many ways, this demonstrates the maturation of the ETF landscape. Investors weren't fooled by the allure of low management fees alone. Looking at the whole picture, they realized that the few basis points gained in management costs weren't worth the trading costs of switching funds.

At the time the article was written, the author had no positions in the securities mentioned. Contact Gene Koyfman at ykoyfman@indexuniverse.com. Follow Gene on Twiiter @GeneKoyfman.

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This article appears in: Investing , ETFs

Referenced Stocks: FLG , IVV , SCHX , SPY , VOO

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