Rebooting Robo Advisors’ ETF Selection

August 25, 2014

When Eight Plus 10 Makes Six

There are eight plain-vanilla U.S. total markets choices, and five vanilla sets of developed ex-U.S. and emerging market pairs to choose from—18 funds, in all. Presumably the robo CIOs want to choose the best in each segment, without regard for branding. Too bad that indexers—and ETF issuers—make mixing and matching nearly impossible.

Actually, it’s not that terrible until you get to the international funds. The U.S. is simple, because you can choose a U.S. total market fund independently of the other two.

Among the U.S. funds, the Vanguard Total Stock Market ETF (VTI | A-100) offers the broadest, most efficient coverage of the U.S. markets, with excellent liquidity. That’s why VTI wins ETF.com’s Analyst Pick award in the Equity: US Total Market segment. Every robo advisor except Invessence chose VTI.

Now we’re down to 10 funds—but not really. You can’t mix and match developed ex-U.S. and emerging market ETFs because of South Korea. S&P and FTSE indexes include South Korea among developed nations; but MSCI groups it with the emerging economies. Index-tracking funds follow suit. SPDRs, Schwab and Vanguard put South Korea in their developed-markets funds; iShares keeps it in emerging markets.

If you combined IEFA and VWO, you would have a gap; namely, no South Korea. But if you held VEA and IEMG, you’d double up on Samsung.

So you have to choose these funds in pairs, to get full international coverage. Robo CIOs either have to stick with iShares, or use some combination of Schwab, SPDR and Vanguard funds. Let’s keep this in mind as we walk through the fund-selection process.

Which Costs Matter Most?

Whether choosing single funds or pairs, investors—robo CIOs and all the rest of us—had best consider three types of costs when choosing ETFs: opportunity cost; holding cost; and trading cost. Of the three, opportunity cost is usually the largest.

Opportunity cost reflects the cost of missing out of the global opportunity set. It’s the future returns of the stocks or bonds you don’t hold. ETF.com’s ETF Analytics reflects opportunity costs in our fund reports; you’ll find it in the “Fit” tab.

Holding costs include obvious factors such as the expense ratio, but also include tracking error as well as securities-lending revenue—as in the securities-lending income, not cost—among others. Look in the “Efficiency” tab of our fund reports for more details.

Trading costs are best represented by spreads, but can include market impact, slippage, and premiums and discounts. You’ll find plenty of information on trading costs in the Tradability tabs of our fund reports.

For the developed ex-U.S. and emerging market funds, the historical average costs stack up like this:

Opportunity: 0.28 percent

Holding: 0.20 percent

Spreads: 0.07 percent

A logical fund-selection process would focus first on minimizing opportunity costs, and second on holding costs. Frequent traders, including those who offer tax-loss harvesting services, will have to balance trading costs with holding costs, weighing the combination against opportunity costs.

That’s what I’ll do in my next blog. Meanwhile, if robo returns head south, don’t blame Canada.


At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner, CFA, at [email protected].

 

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