By Abraham Bailin
In the investment process, once a high-level investment thesis
or allocation decision has been made, the question shifts to how
one can best gain exposure. While there are certainly a number of
considerations, chief among them is cost.
This shouldn't come as a surprise. For years, cost of access has
been a paramount concern. We can trace the trend all the way back
to 1975, when, in founding The Vanguard Group, Jack Bogle built an
investing empire on the back of low-cost investing. Even our
research here at Morningstar has reinforced the idea that costs
make a difference. We've shown that over the long term cost is an
excellent predictor of relative performance; that funds with lower
fees tend to outperform peer offerings.
Within ETF land, the traditional view of cost can be summarized
with two words: "expense ratio." Investors often look to this
metric as the all-in measure of an ETF's cost. Generally speaking,
the expense ratio is a good yardstick. There are, however, a number
of intangibles that, while frequently overlooked, do present the
investor with very real costs.
I'd like to frame the question a bit differently here. I posit
that when considering ETF costs, one should not merely ask what
they charge. Instead, ask yourself what you initially expected to
receive and whether or not it was what the product has provided
Estimated Holding Costs
Most ETFs are index vehicles, and ideally, these funds should track
their index, less the expense ratio. Under the performance tab,
there is a table called "Total Cost & Risk." Our proprietary
Morningstar data point that measures the gap in return between the
ETF and the index is called "Estimated Holding Costs." In addition
to the expense ratio, the estimated holding cost captures the
realized cost of replicating an index. Indexes with high turnover
or relatively illiquid constituents can be more costly to
replicate. For funds that track these types of indexes, we would
expect the estimated holding cost to be higher than the expense
Take for instance two funds tracking very similar indexes, the
Dow Jones U.S. Total Stock Market and the Dow Jones U.S. Index.
They are tracked by SPDR Dow Jones Total Market (
) and iShares Dow Jones U.S. Index (
), respectively. Given the similarity between the benchmarks,
either could be used to gain the same exposure. They maintain a
correlation of 1.00 over the past three years. Both funds charge
exactly 20 basis points per annum. Year to date, IYY has returned 7
basis points less than the index. Given that we are roughly halfway
through the year, the tracking error falls close to the size of the
product's annual fee. The SPDR product, however, has trailed its
index by a larger 18 basis points, year to date.
We can attribute this additional lag to the fact that the SPDR
fund is tracking a total market index which includes all U.S.
securities available to investors, 3,718 securities in total. The
iShares fund tracks an index that includes only the top 95% of the
available market cap, amounting to a total of only 1,340
securities. In other words, we think the reason for the SPDR fund's
greater lag to the index is due to the fact that small-cap stocks
are harder to track, given their lower liquidity.
Generally speaking, the gap in return between the ETF and the
index can be thought of as an additional cost. Note, however, that
these figures will fluctuate from year to year and sometimes can
even be positive. Significant and persistent deviations from
expected levels of excess return should raise eyebrows. A good way
to gauge the potential for deviation from the index is the data
point "Tracking Volatility" (which can be found next to the
estimated holding cost figure), or rather the volatility of the
excess return figure over time. Again, given TMW's greater exposure
to small caps, we would expect this fund to have a higher Tracking
Volatility figure relative to the iShares fund. As such, investors
looking for the best index-tracking ETF would be better off in the
iShares fund. Those who are more bullish on small caps and want
that exposure can pick the SPDR fund, the trade-off being that this
ETF won't track as well as the iShares product.
A second intangible cost comes by virtue of a product's liquidity.
Liquidity can be thought of as the sensitivity of an asset's price
to the act of buying or selling. Assets that can be bought or sold
in large quantities without generating large impacts on the asset's
price are said to be highly liquid. Conversely, assets that suffer
large movements in price in response to small levels of buying or
selling activity are said to be illiquid.
If the size of an order to buy or sell exceeds the number of
shares being offered at the most advantageous price (for buyers the
lowest price available, and for sellers the highest price
available), to fill your order you must accept the next best price.
Consider the following example:
You would like to purchase 10 shares of exchange traded fund
XYZ. The best offer is $5.00 per share. There are five shares
available at this price. You purchase all five. To complete the
trade, however, you must purchase an additional five shares. The
next best price available is $6.00 per share. There are 17 shares
available at the $6.00 price. To complete the order, you purchase
an additional five shares at the $6.00 price. The total purchase
price of the order was $55.00.
By purchasing shares, you moved the price higher. In effect,
your trade had an impact on the market price.
Illiquid markets provide for very serious implications. In the
example above, you initially wished to purchase shares of XYZ at
$5.00, but to fill this order immediately, you had to purchase half
of the order at $6.00. Assuming no transaction fees, you spent a
total $55 to acquire 10 shares. Had you expected to fill his entire
order at the initial $5.00 level, the trade cost you 10% more than
you expected it to. This exemplifies the idea that market
illiquidity can pose a real cost.
While there are sophisticated statistical metrics that can be
used to gauge and project market impact cost, they aren't necessary
for the disciplined, long-term retail investor. Generally speaking,
volume can serve as a decent proxy for liquidity. That said,
trading in ETFs that maintain higher average daily trading volume
numbers will leave you far less exposed to suffering these market
Wrap Up: Best Practices
We don't aim to discount the relevance of the baseline expense
ratio in your investment selection process. We do, however, posit
that there are additional costs that are often less transparent but
nonetheless important to consider. For those making decisions
purely based on annual fees, note that the incidence of negative
excess of return can represent a sizable cost relative to the
expense ratio. While the excess return figure can fluctuate over
time, any excessive or persistent substantial negative excess
return should be taken into account. Also consider the impact your
own trading activity may have on the ETF. If your trades are
sizable, sticking with the most-liquid options can minimize the
cost that your own market impact poses.
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
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