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True cost of an ETF: 4 things to consider

Susan A. Darroch  |  20 Jun 2018Text size  Decrease  Increase  |  
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The exchange-traded fund (ETF) market in Australia recently hit $33.8 billion in funds under management, according to ASX figures. This is an extraordinary milestone for a local industry that hasn’t yet had its 18th birthday.

Investors continue to flock to ETFs. But as the Australian landscape evolves and the product range expands, it is important to understand the different components that make up the true, or total cost, of an ETF. This is an important part of deciding which ETF is most suited to your investment objectives.

Costs do matter. Choosing an ETF that ends up costing more than you expected can erode your portfolio's returns over time. While many investors choose to focus on the expense ratio when evaluating costs, relying on only one factor risks overlooking other factors that impact total cost of ownership.

Let’s dig a little deeper and look at all the factors that impact total cost of ownership.

1. Expense ratios

The expense ratio is the management fee your fund charges on an annual basis. For ETFs, these can range from administrative expenses to custodial and index licensing fees. 

If you compare the expense ratio of an average Australian shares large cap blended ETF at just 29 basis points (bps), against the 131 bps for managed funds in the same category, ETFs can have an advantage.

However, savings from a reduction in fees can be offset by other factors, such as commissions, bid/ask spread, and the tracking error. Investors need to look beyond just the expense ratio when determining the true cost of the ETF they are buying.

2. Commissions

This refers to the fees brokers or investment advisers charge in return for providing financial advice or handling the purchase or sale of a security. Charging commissions on client transactions is how many full-service brokerages make their profits.

While commissions will vary from firm to firm, investors who frequently trade securities – including ETFs – will have higher commission fees. This means that a large number of commissions can actually offset the savings from low fees or costs that investors may generally find in ETFs.

3. Bid/ask spread

This is the difference between the bid – the price at which a buyer is willing to buy an ETF – and the ask – the price at which the seller is prepared to sell. The spread indicates the overall cost of transacting in securities and is a cost associated with transacting on the secondary market, or at exchange level.

The spread can be impacted by a number of factors which in turn can add additional costs to buying an ETF. These factors include:

  • trading volumes
  • increases in risk
  • the spread of the underlying securities in an ETF market
  • creation/ redemption fees, which can make transacting on the secondary market more expensive for investors.

4. Tracking error

Understanding the tracking error is another important factor in determining total cost. The tracking error is the difference between an ETF’s net asset value performance and the total return of the underlying index. Depending on how long an investor plans to hold their ETF, they may monitor the tracking error daily, monthly, quarterly or annually.

With an ETF that seeks to track the performance of an index, the fund should emulate the underlying index. Large differences in the performance between the fund and the index could signal poor fund management or excessive trading costs.

When evaluating tracking error, it is important to look at the fund’s underlying index. Index construction, index methodology and any tracking differences can all offset the benefits of a lower expense ratio. For example, an ETF that frequently adds or removes holdings can impact how tightly that ETF tracks its underlying index by changing its exposure. This could add extra trading costs and reduce investor returns.

As you can see, it’s important to look beyond singular factors like the expense ratio and understand the unique structure of each fund to uncover the true cost of an ETF. Too much focus on any one factor may mean you miss out on valuable information and end up paying more than you had expected.

 

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Susan A. Darroch is the head of global equity beta solutions, Asia Pacific ex Japan, State Street Global Advisors Australia. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

 

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