That ETF’s Expense Ratio Stole My Alpha

May 29, 2014

Expense ratios matter in ways some investors don't think much about.

A few weeks ago, I published a blog called "'Smart Beta' 5: No Alpha Here."

My findings—no statistically significant alpha in outperformance-claiming U.S. large-cap funds—made some folks hopping mad.

A few attacked my character, but others had something substantial to say. Here are a few of the latter comments:

"There are back-tested index results for something like SPLV [the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-47)] that go back 20 years or so." —Nick Carver

"In my research of 'smart beta' indexes (not the ETFs), specifically the Russell Fundamental Indexes, I have seen huge alpha over the long run. I will concede that the Russell fundamental indexes aren't the actual ETFs." —MC

MC, you are wise. The indexes are not the ETFs.

ETFs are miracles of modern financial engineering. ETFs allow anyone to hold a diversified basket of securities, often for mere pennies. But they're not made of fairy dust. They hold, and trade, actual stocks, bonds, currencies, commodity futures, etc.

These real-life portfolios aren't free. They have management fees, and tracking error, in addition to trading costs. Those costs can kill a fund's alpha.

It's entirely possible that an index can have statistically significant alpha, but an ETF tracking that index doesn't.

That's exactly what happened to two funds I analyzed in that provocative blog: Nick Carver's example SPLV and the WisdomTree LargeCap Dividend Fund (DLN | A-95).

I revisited the 11 funds from the "no alpha" blog to measure alpha slippage between fund and index. I had to drop two funds for lack of clean index data.

This time, I used the S&P 500 Index as my bogey, because, unlike's chosen U.S. Large Cap segment benchmark, the S&P 500 has ETFs that track it—three, in fact. I chose the iShares Core S&P 500 ETF (IVV | A-97) as the most efficient S&P 500 ETF with at least five years of performance history.

I ran two sets of regressions: fund versus fund (NAVs), and index versus index. For example, I compared SPLV's returns with IVV's, and, separately, the S&P 500 Low Volatility Index to the S&P 500 index (total return versions, in all cases). I covered one-, three- and five-year periods ending on March 31, 2014.

The results were similar in all time frames. The most interesting—the three-year set—is below; you can find the other two at the end of this blog.

Three Years to March 31, 2014
Expense Ratio Goodness of Fit Beta Alpha Annualized Significance
DLN 0.28% 0.97 0.85 2.48% 93.69%
DLN Index 0.97 0.85 2.70% 95.53%
EPS 0.28% 1.00 0.98 0.74% 77.08%
EPS Index 1.00 0.98 0.92% 86.22%
EWRI 0.40% 0.96 1.09 -1.29% 46.24%
EWRI Index 0.96 1.09 -1.00% 36.46%
FEX 0.66% 0.98 1.09 -1.73% 74.91%
FEX Index 0.98 1.09 -1.09% 52.99%
PRF 0.39% 0.99 1.03 -0.05% 4.02%
PRF Index 0.99 1.03 0.28% 20.97%
RSP 0.40% 0.98 1.10 -1.07% 56.20%
RSP Index 0.98 1.10 -0.73% 39.99%
SPHB 0.25% 0.93 1.60 -11.62% 99.43%
SPHB Index 0.93 1.60 -11.44% 99.36%
SPHQ 0.29% 0.97 0.89 2.72% 90.79%
SPHQ Index 0.97 0.89 3.05% 94.06%
SPLV 0.25% 0.85 0.68 4.54% 88.36%
SPLV Index 0.85 0.68 4.78% 90.11%

Three takeaways for comparing the index versus index regressions to the fund versus fund ones:


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