Funds with the highest fees reflect the costs of the strategy, not of the management.
ETF proponents like me can get unbearably smug when bragging about the low costs of ETFs. Like all good boasts, there’s truth in it: ETFs excel at delivering big broad portfolios at tiny all-in costs, with tax efficiency to boot.
But with more than 1,650 ETFs on the market and counting, many funds range far beyond the confines of plain-vanilla U.S. equities, where the cheapest funds can be found. At the extreme, the headline fees for some of the more exotic ETFs can be eye-popping.
The chart below comes from our ETF finder. It’s simply a list of 10 of the most expensive ETFs, sorted by expense ratio from high to low.
|High Fee Reason|
|BIZD||Market Vectors BDC Income||9.17%||Acquired fund Fees|
|AMLP||Alerian MLP||8.56%||Deferred Tax Expense|
|MLPA||Global X MLP||7.67%||Deferred Tax Expense|
|YMLI||Yorkville High Income Infrastructure MLP||6.92%||Deferred Tax Expense|
|MLPJ||Global X Junior MLP||5.11%||Deferred Tax Expense|
|YMLP||Yorkville High Income MLP||4.65%||Deferred Tax Expense|
|AGLS||AdvisorShares Accuvest Global Long Short||4.28%||Short Interest|
|SOYB||Teucrium Soybeans||3.97%||Tiny AUM|
|SIZ||QuantShares U.S. Market Neutral Size||3.81%||Short Interest|
|WEAT||Teucrium Wheat||3.74%||Tiny AUM|
Source: ETF.com 9/30/2014
These fees are roughly 100 times more than the cheapest ETFs. Are the issuers of these ETFs really pocketing fees that are 100 times more than those of the cheapest funds?
Not exactly. The largest component of the high fees below typically reflects a set of costs directly associated with running the strategy, rather than managers’ fees.
Russian Dolls (Acquired Fund Fees)
The drivers of the fees in the top 10 fall into four groups.
The first of these are the acquired fund fees that apply to the Market Vectors BDC Income ETF (BIZD | D-99). The fund holds publicly traded business development companies (BDCs)—firms that invest in other companies at the capital structure level. The BDCs themselves can be thought of as investment vehicles with their own expenses.
BIZD, as required by the Securities and Exchange Commission, reports the fees of its BDCs as an expense-ratio line item. The acquired fund expenses aren’t extracted from the net asset value (NAV) by BIZD’s managers; instead they are reflected in the performance of each holding.
Do the BDCs’ expenses affect the performance of BIZD shares? Yes. This highlights an important fact that applies throughout this entire discussion: The performance record of BIZD is net of these fees.
Note that acquired fund fees aren’t confined to BDCs: They often turn up in less dramatic fashion in ETFs that hold other ETFs.
A Tax Middleman (Deferred Tax Expenses)
Funds like the massive Alerian MLP ETF (AMLP) report high fees due to their unique legal structure. As a C-corporation, AMLP is taxed at the fund level, unlike most ETFs. In short, the underlying portfolio of master limited partnerships is marked to market daily, and taxes on gains are accounted for on an ongoing basis. The fund is required to state the tax for the previous 12 months on its prospectus.
As with the BDC example, the deferred tax expense reflects the cost of running the strategy—accessing MLPs in a C-corp wrapper. And the cost also shows up in the daily share performance of AMLP. Taxes on gains at the fund level ultimately go to the government, not to the ETF issuer.
Borrowed Time (Short Interest Expense)
Taking short positions costs money. The AdvisorShares Accuvest Global Long Short ETF (AGLS | F-39) bets in part that stocks in certain regions will fall rather than rise. The short interest is the cost to borrow the securities (which are then sold) and to maintain a margin account. Again, it’s the execution of the strategy that costs money. Short-interest expense definitely impacts the bottom line, but it’s not a fee collected by managers.
The Wallflower Effect (Tiny AUM)
The high headline fee of the Teucrium Soybeans ETF (SOYB | 11) differs from the other three types of costs I mentioned. It results from a combination of the accounting associated with its legal structure and its lack of popularity.
As a commodities pool, the SOYB prospectus states its expenses as a breakeven amount. The largest component is the ratio of the fixed costs of running the fund in dollars, divided by assets under management. The fund is tiny by ETF standards, with just $4 million in assets, which drives the breakeven figure skyward.
The difference here versus the other high-cost drivers is that SOYB’s high fee would go away if the fund were more popular. (SOYB’s sister fund, the Teucrium Wheat ETF (WEAT | F-100)) has a high fee that will likely drop due to sizable inflows since fund documents were last published.) That’s not the case for funds like BDC, AMLP and AGLS, whose high headline fees aren’t driven by assets under management.
With the exception of the unpopularity problem SOYB has, the high fees here reflect costs you’d bear if you tried to execute the strategy on your own. The simple takeaway is to have high conviction if you want to invest in an expensive strategy, because the ETFs that deliver these strategies faithfully pass on their expenses.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.