Sexy headlines about rock-bottom ETF expense ratios totally miss the real point on costs.
We’ve all seen it in the past few weeks—ETF issuers are in a race to zero when it comes to expense ratios. Too bad everyone has their eyes on the wrong set of costs.
Vanguard, Schwab and iShares have been at the forefront of the new ETF price war.
From launching new products such as the iShares Core MSCI Emerging Markets ETF (NYSEArca: IEMG) to slashing fees on funds like the Schwab U.S. Broad Market ETF (NYSEArca: SCHB) to cutting off ties to index names like MSCI, ETF firms have done everything in their power to gain ground in the price war.
The thing is, as ETF issuers focus on cutting costs down to zero, there’s been little focus on what I would argue is the most significant cost in the ETF space—trading expenses.
The Most Obvious Cost: Bid/Ask Spreads
Investors experience trading costs in a variety of ways. The most obvious is bid/ask spreads: the difference between the ask price—the price at which you can buy the ETF; and the bid—the price at which you can sell the ETF.
To get that in percentage terms, you simply divide that difference by the midpoint between the bid and the ask price.
Recently, there’s been a lot more discussion on how bid/ask spreads can affect trade executions for ETF investors. Often, issuers like to point out that they have the cheapest funds when spreads are taken into account.
The cost case for the iShares Gold Trust ETF (NYSEArca: IAU) vs. the SPDR Gold Shares ETF (NYSEArca: GLD) is one that one of my colleagues has mentioned before.
As a retail investor wishing to buy the funds in the secondary market and hold them for a year, you’re looking at a total cost of 0.41 percent for GLD, and 0.31 percent for IAU.
The above example doesn’t tell the whole story for institutional investors, which my colleague Paul Baiocchi mentioned in another blog. Still, the truth is that I can never really agree with the spread and expense ratio calculation I’ve seen quoted by some.
Issues Incorporating Bid/Ask Spread Costs
For one, this sort of math always assumes that investors capture the spread when trading an ETF—meaning you’ll actually realize these “in and out” costs of a trade. But that’s not really the case.
Market makers can often walk an order up; that is, increase their asking price or, conversely, decrease their buying price. That basically moves the market if they begin to notice there might be size behind the order. As a market maker, you’d be stupid not to, as long as competition wasn’t too close behind you in making markets. Sorry folks, bills have to be paid.
Secondly, the denominator in the math is simply wrong. The expense ratio is a fixed cost based on the net asset value of the fund (NAV), while the spread is a varying cost based on the midpoint between the bid and the ask price.
Simply put, the denominators in both costs are not the same.