Expense Ratios Can Be Poor Cost Indicators

October 23, 2013

USA Today’s Matt Krantz was faced this week with an investor question we often hear ourselves: Which ETFs have the highest expense ratios?

The idea here is that the more you pay for an ETF, the less you keep in your pocket. And that concern is certainly valid, particularly in an era when investors are so focused on finding sources of income given compressed interest rates and a challenging global economy.

Unsurprisingly, Krantz began his response by singling out the Market Vectors BDC Income ETF (BIZD | C-0), which comes with a reported expense ratio of 8.33 percent—the highest in the 1,509 U.S.-listed ETF market, bar none. That’s high, so, fair enough.

However, when it comes to ETFs, the headline cost we see in the form of an expense ratio is often a poor indicator of just how much it costs investors to own a given fund.

Take the U.S. large-cap equity space, for instance. There are 61 broad-based ETFs tapping into that segment, with many of them serving up very similar exposure to the space, and none comes with a lower expense ratio than the Schwab U.S. Large Cap ETF (SCHX | A-93), at 0.04 percent a year, or $4 per $10,000 invested.

Buying into that ETF, which has now accumulated more than $2 billion in assets in under three years, would give you liquid exposure to some 750 U.S. large-cap companies in a diversified portfolio. In fact, it’s fair to say that SCHX is a great choice for any investor looking for broad U.S. large-cap exposure, and for a steal of an expense ratio.

Despite trading one penny wide, because of its low share price, SCHX trades at 4-basis-point spreads on a percentage basis, which are relatively wide in the segment. The wider the spread, the more it costs investors to own the fund. In fact, once you take spreads into account, owning SCHX over the course of a year costs investors closer to 0.08 percent, or twice its expense ratio.

That added cost applies even if you are a long-term buy-and-hold type of investor because regardless of your holding period, you still have to pay half the spread when you buy into the fund, and half when you sell.

One of SCHX’s main competitors is the $12.6 billion Vanguard S&P 500 ETF (VOO | A-97), which comes with a stated expense ratio of 0.05 percent a year, or $5 per $10,000 invested—just higher than SCHX’s price tag by a tiny margin. VOO has the same one-penny spread as SCHX, but because of its higher share price, it is more efficient to trade, with an average trading spread that is nearly neglible at 1 basis point. It also has massive liquidity, trading more than $180 million per day.

VOO also does a superb job at replicating its index, underperforming its benchmark by only 0.03 percent on a median basis in the past 12 months—or less than the fund’s overall expense ratio. Looking at that median tracking difference is another vector into a fund’s actual cost of ownership.

ETFs usually underperform their indexes on a median basis by more than their stated expense ratio, and that difference translates into an added cost to investors. That’s because the actual cost to VOO investors of owning—in this case—the 500 stocks in the S&P 500 index, is ultimately the difference between the return on those stocks in the index and the return of the ETF. But since there’s a cost to buy, sell and manage that portfolio of stocks, there’s usually a gap between the ETF and the index's performance, or the so-called tracking difference.



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