Choosing the right fund should be more about how an ETF tracks its index than about its expense ratio.
There’s been quite a bit of hullaballoo lately over whether iShares raised the expense ratios on 40 of its funds.
Recently filed prospectuses, which became effective on Jan. 1 but covered fund economics for the 12 months ended Aug. 31, 2012, indicate that the expense ratios on 40 funds rose.
But officials at iShares say the expense ratios listed in those prospectuses are backward-looking and no longer accurate, and that it’s not raising any fees. In fact, thanks to asset growth at iShares, the fees that investors experience in 2013 may be lower than either the latest prospectuses or the iShares website currently suggests.
Confused? That’s OK, because any changes to these expense ratios don’t really matter.
Whether the fee on a fund like the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) is 0.67 percent—as iShares’ website says—or a few basis points more, as the latest prospectus indicates, shouldn’t change the analysis that leads an investor to invest in the fund in the first place.
After all, an investor already now has access to much cheaper emerging markets exposure in the similar iShares Core MSCI Emerging Markets ETF (NYSEArca: IEMG), which has a 0.18 percent annual fee.
If you’ve already chosen EEM over IEMG, do you really care whether the expense ratio difference is 0.49 percent or 0.51 percent? Probably not.
But that’s not even my main point.
The real reason it doesn’t matter is that the expense ratio is only part of the equation when it comes to determining the true cost of your exposure to an index. The expense ratio matters to the issuer, since it determines how much it gets paid, but it shouldn’t necessarily matter to the investor.
After all, when you buy an index-based ETF, the important thing is how closely the ETF tracks its underlying index.
Generally, the expense ratio is the best predictor of that tracking difference, since you’d expect a perfectly tracking ETF to deliver the returns of its index minus its expense ratio. But that’s not always the case.
First of all—and this one is obvious—not all ETFs track their indexes perfectly. Even if they fully replicate their underlying indexes, ETFs have to contend with things like trading costs that their indexes don’t. Many ETFs earn additional revenue by lending out their securities, which can pad returns, and many also optimize their portfolios, which can lead to either positive or negative tracking error.
Thus, the important thing to look at isn’t expense ratios, but rather how much the ETF has actually tended to lag its underlying index.
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.
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].