Credit: Shutterstock photoInvestors who are evaluating exchange-traded funds (ETFs) for their portfolio often compare the expense ratio of multiple funds as a measure of cost. All things being equal, the funds with the lowest total cost will allow you to keep a greater portion of your returns. This is why so many investors have gravitated towards ETFs as a more efficient means of getting diversified exposure to stocks, bonds, and commodities.
The majority of ETFs have ultra-low expenses when compared against actively managed mutual funds, hedge funds, and even insurance products. However, that doesn’t mean that all of them are created equal or that there aren’t a few confusing ETFs with non-traditional fee structures.
Two ETFs that are often touted as the lowest cost in the world are the iShares Core S&P Total U.S. Stock Market ETF (ITOT) and Schwab U.S. Broad Market ETF (SCHB). Both vehicles charge a simple expense ratio of 0.03% per year for their ongoing maintenance and viability. That’s just $30 for every $100,000 invested in either fund.
A decade ago such low fees would have been entirely unthinkable on Wall Street. Now firms such as BlackRock, Charles Schwab, and Vanguard are competing for greater shares of the ETF marketplace by lowering prices nearly every year. That makes for a compelling advantage for the end consumer (you!).
The flip side of the coin are ETFs with inexplicably high fees that track esoteric or non-traditional asset classes. These may include: business development companies, master limited partnerships, commodity futures, volatility indexes, and leveraged sector funds.
According to ETFDB.com, the ETF with the highest net expense ratio is the VanEck Vectors BDC Income ETF (BIZD), which charges 9.45% annually. BIZD tracks a niche basket of 25 publicly traded business development companies and has $84.1 million in total assets.
While paying a 9%+ expense may sound crazy or downright greedy on the surface, there is much more to how this number is derived. Van Eck actually has an excellent explanation here on how they calculate acquired fund fees, management fees, and other expenses. Below are some simple explanations of this process:
- Management Fee: 0.40%, includes the direct cost of maintaining the fund.
- Other Expenses: 0.18%, includes cost of custody, trading, and extra direct expenses.
- Acquired Fund Fees: 9.04%, an indirect expense that is born from the underlying holdings. In the case of BIZD, this may include operating expenses of the stocks and external management fees of other related companies.
- Gross Expense Ratio: 9.62%, the sum total of direct and indirect expenses.
- Fee Waivers: -0.17%, a reduction in fees offered by the sponsoring fund company for a specific period of time outlined in the prospectus.
- Net Expense Ratio: 9.45%, the final expense paid by shareholders after all fee waivers have been accounted for.
While indirect expenses can often seem exorbitant, they are often costs that would be borne by a shareholder that took direct ownership of the underlying holdings without the ETF wrapper. They are simply being disclosed in the interest of transparency according to SEC guidelines.
Another example are ETFs that invest in master limited partnerships such as the Global X MLP ETF (MLPA), which discloses a deferred income tax liability in their fee structure. The management fee of MLPA is just 0.45% with a deferred income tax expense of 3.54% tacked on as well. This allows the fund to pay special taxes associated with the distributions of the underlying holdings.
The Bottom Line
In a plain basket of stocks or bonds you are most likely only going to encounter a simple expense ratio that is easy to understand. However, more complex strategies, niche sectors, or “fund of fund” style ETFs are going to be required to disclose additional costs.
The lesson here is to carefully research this information in the ETF prospectus and understand the fees that are paid directly to the fund company versus those that are the result of a particular asset class.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
