When it comes to buying ETFs, investors are understandably focused on the fees. But as the fund price war looks set to slow down, one expert is reminding investors that an excessive focus on fees for ETF selection may be misguided.
“[I]t’s important to look beyond the headline fee and take a more holistic approach to assessing the cost of ETF ownership,” said Ben Johnson, Morningstar Director of global ETF research, in a new blog post.
As cited in ThinkAdvisor, Johnson said the costs of ETF ownership can be split into two major categories: holding costs and transaction costs. Whereas transaction costs include commissions, bid-ask spreads, and market impact, holding costs encompass fees, and other factors that can affect the tracking performance of an ETF.
Holding costs are typically a bigger consideration for long-term investors who hold the product, while transaction costs tend to add up and become significant for short-term investors, notably those who “are looking to invest large sums of money.”
“The manner in which funds seek to replicate their benchmarks can also be a substantial source of implicit holding costs,” Johnson said. Sampling, wherein a basket of stocks is chosen to mirror a particular index in an attempt to replicate its returns, could result in a tracking differential to the benchmark.
Tracking issues may also arise from index turnover, which occurs when companies in an index go through bankruptcies, mergers, or acquisitions. Because the portfolio must be realigned to reflect these changes, the fund could end up with a performance differential relative to its benchmark.
Risks particular to dividend-seeking ETFs include the timing and tax treatment of dividend payments, which may lead to tracking issues. Depending on how the portfolio manager handles the cash — particular when the manager can’t “equitize [the] cash by investing in futures to maintain market exposure and ensure tight tracking” — the lapse between the funds’ ex-dividend dates and dividend payment dates may affect tracking performance.
The tax treatment of dividends, particularly for international equity funds that might be located in multiple jurisdictions, may also have an impact on performance. For better or for worse, Johnson explained, the tax treatment baked into the calculation of an index may vary from the “reality of the fund.”
And while securities lending is a revenue source that ETF providers can use to offset holding costs and ultimately cut fees, the lending activity matters. For example, Johnson said, small-cap funds tend to earn more in securities lending than large-caps.
“ETFs and index funds would be expected to product returns that lag its benchmark by an amount equal to its expense ratio,” he said. Tracking error, a measure of the standard deviation of the difference between an ETF’s return and its benchmark’s return over time, must also be considered.
And of course, short-term investors who trade more than they hold must watch out for the trading costs, bid-ask spreads (which vary largely due to market liquidity and volatility), and the impact of market movements.
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