The total cost of owning an exchange-traded fund (ETF) can be roughly split into two parts: holding costs and transaction costs. Holding costs come with owning an ETF. Trading costs are paid as investors buy and sell.

Total Cost of Ownership = Holding Costs + Transaction Costs

Holding costs include fees and various other factors that affect an ETF’s performance. Transaction costs can have an impact on the effective price paid for buying or selling an ETF. How important these two costs are relative to each other depends on an investor’s time horizon and the amount of money invested. For investors with long time horizons, holding costs matter more than transaction costs. The opposite is true for investors with short time horizons.

ETF holding costs

Annual fee

An ETF’s annual fee is the most obvious holding cost for an ETF investor. It’s taken as a percentage of an investor’s stake in an ETF. An investor with a $10,000 stake in an ETF charging 1% would pay $100 in fees paid per year. Investors should prefer low-fee products to high-fee products, as the growth of $10,000 chart below illustrates.

Growth of $10,000 with fees

Sampling

Sampling is a method index fund managers like Vanguard, iShares, or State Street use to closely track their indexes. These firms (and numerous others) will selectively sample securities from their target indexes to achieve representative exposure. This means that even if an ETF holds fewer stocks or bonds than its index, both should look basically the same. The more a fund’s portfolio is sampled, the more likely its performance will diverge from the index it follows. This could lead to an unintended drag on performance.

Turnover

Turnover measures the percentage of a portfolio that is different from year to year. ETFs cycle through stocks or bonds each year at different rates depending on their investment strategies. ETFs with a high turnover ratio (expressed as a percentage) may incur higher transaction costs as they buy and sell portfolio securities than ETFs with a lower turnover ratio. ETF managers are generally good at managing transaction costs, but high turnover can add up and erode returns.

Dividends

Dividends of stocks held in ETFs can also affect the return an investor receives from a fund. The impact those dividends have on performance comes down to factors including investment area. Managers of ETFs that invest in international markets must deal with a labyrinth of tax rules for the countries the stocks they hold inhabit. These tax rules may be favorable or unfavorable to the investor.

Securities lending

Securities lending is one of the rare chances ETF managers have to offset some of an ETF’s cost for investors. They do this by lending out portfolio securities and making a small profit from the transactions. That profit helps offset an ETF’s fee. The practice is low-risk for both the ETF issuer and investors, but investors should note that the ETFs with the highest securities-lending returns are usually some of the riskiest.

How to measure ETF holding costs

The five types of holding costs create a gap between the performance of an index-tracking ETF and its benchmark. Tracking difference and tracking error are two common measures of this rift.

For active ETFs, holding costs are still present, but their influence on performance can be more difficult to quantify. High fees are more prevalent among this group, but history still supports low-cost active ETFs having the upper hand.

Tracking difference

All else equal, index ETFs should produce returns that lag their benchmarks by an amount equal to their annual fees. For example, assume an investor owns an ETF that tracks the S&P 500 and charges an expense ratio of 0.25%. If the S&P 500 rises 10% in a year, the investor’s return, after fees, would be 9.75%:

Tracking Difference = ETF Return - Benchmark Index Return

Fees are the most predictable and readily quantifiable source of the tracking difference between ETFs and their reference indexes.

Tracking error

It’s important to distinguish between tracking difference and tracking error. Tracking difference is simply the difference between an ETF’s return and that of its benchmark during a given period. Tracking error measures the standard deviation of the difference between an ETF’s return and its benchmark’s return over time.

ETF transaction costs


Commission

Commission is the most obvious transaction cost an investor faces when buying or selling an ETF. However, most investors will avoid this cost because many brokerages and online trading platforms charge investors little to nothing to buy or sell an ETF. Low- or no-cost brokerages like Superhero and Pearler have all but removed commissions from the ETF cost equation.

Bid-Ask/Buy-Sell spread

Bid-ask or buy-sell spread is the difference between the share price at which a market maker is willing to buy an ETF (the bid) and the price they’re willing to sell it (the ask). Buyers and sellers pay to cross this spread. While typically small, spreads tend to be wider for certain types of strategies. The wider the spread, the greater the cost to an investor. If buying or selling ETFs frequently, or in large quantities, costs can add up quickly.

Market impact

Market impact is how much a trade might move the market. Smaller investors don’t have to worry about this, but it can be a major consideration for institutional investors. A big trade in a small ETF may move the ETF’s share price against the investor. For example, a large buyer might eat through offers at multiple price levels, pushing up the price paid and essentially creating a transaction cost.

The cost of ETF ownership: The bottom line

The total cost of owning an ETF is typically most sensitive to an ETF’s fees and the investor’s time horizon. Transaction costs matter far more than holding costs for short holding periods, while holding costs matter more for longer holding periods. Over time, the total cost of ownership will often converge with an ETF’s annual fee, so long-term investors should pay close attention to the annual fees of the ETFs in their portfolios.

 

This article has been republished from the Morningstar Canada website and adapted for an Australian audience.