How To Get An Almost Free ETF Portfolio

April 29, 2014

Imagine two ETFs that track the same index and charge 0.10 percent per year in annual fees. At first glance, you might expect both to trail their benchmarks by the same 0.10 percent per year. You might not care which of the two funds you pick.

But what if I told you that, on average, one fund lagged its index by 0.20 percent per year, while the other missed by just 0.05 percent? You would choose the one that lagged by just 0.05 percent, 10 times out of 10.

That kind of performance variation happens all the time in ETFs. The reason is that managing an index fund is hard. Some ETFs track more difficult indexes than others; some use sampling strategies rather than fully replicating their index; some trade more than others; some engage in securities lending to earn extra income; and, frankly, some fund managers are just better than others.

We monitor how well funds track their indexes in our free ETF Analytics tool, using a statistic called “Median Tracking Difference.” It looks at how much an ETF has lagged its index over the average one-year period, examining all possible periods over the past two years. It’s an amazing statistic that tells amazing stories.

Take the Schwab U.S. Broad Market ETF (SCHB | A-100). The fund is the cheapest ETF in the United States, offering broad-based exposure to U.S. equities for a fee of just 0.04 percent per year. But that actually undersells just how good SCHB is!

SCHB has actually matched its index perfectly over the average given one-year period. Not only is it charging just 0.04 percent a year, it’s making that 0.04 percent up through smart management and securities-lending strategies. In other words, you’re getting broad-based equity exposure for free.

The Vanguard FTSE Developed Markets ETF (VEA | A-91) does even better. Not only does VEA have an ultra-low fee of just 0.09 percent per year, it has actually beaten its index by 0.15 percent per year on average over the period we studied.

If you take the broad-based ETF with the best median tracking difference in each asset class, based on the data we have, you end up with a portfolio with a blended median tracking difference of negative 0.03 percent per year (negative 0.027 percent if you’re being exact).

The World’s Lowest-Realized-Cost Portfolio
Asset Class Weight Fund Ticker Expense Ratio Median Tracking Difference
U.S. Equity 40% Schwab U.S. Broad Equity ETF SCHB 0.04% 0.00%
Developed Markets Equity 30% Vanguard FTSE Developed Markets VEA 0.09% 0.15%
Emerging Markets Equity 5% SPDR S&P Emerging Markets GMM 0.14% -0.40%
Fixed Income 15% iShares Core Total U.S. Bond AGG 0.08% -0.14%
REITs 5% Vanguard REIT VNQ 0.10% -0.05%
Commodities 5% UBS Etracs DJ-UBS Commodity TR ETN DJCI 0.50% -0.57%
SUM -0.03%

 

That is flat-out awesome. For just $2.70/year for each $10,000 invested, you’re getting 4,000 stocks, 1400 bonds, 40 countries and so on.

To put that in perspective, the average actively managed mutual fund charges 1.33 percent per year. You could own the World’s Lowest-Realized-Cost ETF Portfolio for 49 years for the same cost as holding that average actively managed mutual fund for the next 12 months.

There are reasons investors focus heavily on expenses. Expenses are fixed fees and are guaranteed to detract from your returns.

Tracking difference, by comparison, is variable, and can be impacted by changing events. Still, it’s the best available measure of what investors in each fund have experienced, and is fairly stable for mature ETFs. And as the portfolio above shows, you can use it to find one heck of a deal.


At the time this article was written, the author held a long position in VEA. Contact Matt Hougan at [email protected].

 

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