The first is commissions. While most retail investors trade through discount brokers that charge under $10 a trade, most institutions think by-the-share.
Back when Matt Hougan and I ran mutual funds, our trading desk paid something like 2 cents a share on every trade. In return, we got human beings on the phone to help us work trades, access to both the occasional hot initial public offering allocation and research from our trading partners. While commissions have come down (often less than a penny a share), they’re still a real cost of doing business.
In the ETF space, where hundreds of institutions are often trading the most popular funds with rapid-fire 100-share lots, those commissions can add up quickly. It may only be a buck to trade those $100 shares, but if you’re fancy black box is doing it 10,000 times a day … you get the picture.
The second problem is spreads. While sub-penny trading does happen off-exchange, the vast majority of trading still happens in dollars and cents. Most of the top 100 ETFs ranked by volume trade with as tight a spread as possible—1 penny wide.
That means if the true fair value of something is $100, you’ll pay $100.01 to buy it and maybe can sell it for $100 even—though that spread obviously sloshes around constantly as supply and demand dictates which side of “fair” the market wants to be. But if those shares have a handle of $10 instead of $100, your spread costs you 10 times as much.
Don’t think this matters? Let’s consider a hypothetical example:
A Pithy Hypothetical
Let’s say I want to put $1 million to work in Japan for a week, because I have some hunch (not that I’d recommend that). I look at the market for the most liquid Japan ETFs and I find the iShares MSCI Japan ETF (EWJ | B-97) and the WisdomTree Japan Hedged Equity ETF (DXJ | B-63). Both of these ETFs trade hundreds of millions of dollars a day—my $1 million just isn’t going to move prices around.
DXJ costs 48 basis points a year, or $48 for each $10,000; while EWJ costs 50 basis points. I’m smart enough to know that 2 basis points over a one-week holding period won’t make a darn bit of difference, and will be overwhelmed by the differences in holdings—especially considering that DXJ is currency hedged).
But then I get to the transaction math. As I write this, EWJ has a price of $11.77. DXJ has a price of $54.36. Both trade a penny wide, all day, every day. Let’s imagine I pay half-penny a share in commission. Here’s how that looks to me: