In The End, Expense Ratios May Not Matter

January 02, 2013

 

If an ETF costs 0.20 percent a year but does a terrible job with tracking its underlying index and tends to lag it by 0.50 percent, it’s not any more attractive to me as an investor than a fund that both charges 0.50 percent and lags its index by 0.50 percent.

One way to look at the tracking difference—and the one we use in ETF Analytics—is to look at the rolling 12-month differences between an ETF’s return and its underlying index’s return.

In other words, you calculate the difference between the ETF’s returns and the index’s returns over the 12-month period ending today, and then work your way back using rolling 12-month periods ending yesterday, the day before, etc., until you have a reasonably sized data set.

Our ETF Analytics data set, for reference, covers two years of data, or about 255 12-month return tracking differences.

So let’s look at some of the biggest iShares funds that we originally reported had raised their expense ratios. By assets, the five biggest are:

  • iShares MSCI Emerging Markets ETF (NYSEArca: EEM), with $48.2 billion
  • iShares MSCI Brazil ETF (NYSEArca: EWZ), with $9.3 billion
  • iShares MSCI Japan ETF (NYSEArca: EWJ), with $5.2 billion
  • iShares MSCI Canada ETF (NYSEArca: EWC), with $4.7 billion
  • iShares MSCI Germany ETF (NYSEArca: EWG), with $4.0 billion

 

It turns out that the median tracking differences on all five funds are significantly lower than the expense ratios—on average, iShares is doing better than you’d expect by looking at the expense ratio alone.

EWG, to take the most extreme example, charges 0.51 percent in fees, but only lags its index on average by 0.04 percent, making it practically free.

Given that, the concern over whether the expense ratio is 1-2 basis points higher than it was previously is virtually moot.

 

Top 5 ETFs by AUM

 

It’s worth noting that the range of tracking differences on some of these funds—most notably, EEM and EWZ—is quite broad, so the median tracking difference isn’t necessarily what you’ll get. But it’s still a better indication of the true cost of your index exposure than the headline expense ratio.


At the time this article was written, the author held no positions in the securites listed. Contact Carolyn Hill at [email protected].

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