Don’t Choose An ETF Based On Fees Alone

Todd Rosenbluth is director of ETF and mutual fund research at CFRA.

A purveyor of fine wine or well-aged cheeses can justify a premium from the market, but investors are regularly on the prowl for the lowest-cost product. Sometimes, cheaper is not better.

Last week, Vanguard continued its tradition of lowering the expense ratio of its index-based mutual funds and ETFs with the fee reduction of several dozen equity, fixed-income and asset allocation funds across various share classes. Vanguard also reported one portfolio had a fee increase. You can see all the details here.

CFRA expects the variety of lower-cost passive products will further cause investors and advisors to shift money away from actively managed funds, in light of the performance challenges. In the three-year period ended 2016, just 7% of active large-cap mutual funds outperformed the S&P 500 Index.

Investing Goals More Easily Achieved

Overall, fee compression is worth applauding, as the more money being put to work in investor portfolios will help them better achieve their long-term goals.

For example, Vanguard trimming the fee for its S&P 500 Index products—the Vanguard 500 Index Admiral class (VFIAX) and Vanguard 500 Index ETF (VOO)—by 1 basis point to 0.04% will enable shareholders to better replicate the performance of the large-cap index.

While VFIAX is 1 basis point more expensive than the Schwab S&P 500 Index (SWPPX), VOO’s fee matches the iShares S&P 500 (IVV), and will help Vanguard narrow the minor potential performance gap between its offerings and competing products. They all hold the same large-cap securities at the same weighting, and management does a similarly strong job tracking the index.

Where Lower Fees Are Not As Meaningful

However, most of the other fee cuts took place in ETFs and mutual funds that aren’t really matched by their passive peers.

For example, the expense ratio for the Vanguard FTSE Developed Markets ETF (VEA) fell by 2 basis points to 0.07%. This makes VEA 1 basis point cheaper than the iShares Core MSCI EAFE Index (IEFA). However, IEFA’s 11.2% year-to-date gain through April 27 was ahead of VEA’s 10.4%, as performance is driven more by holdings than fees. VEA has exposure to Canada (8% of assets) not found in IEFA, and it has a lower stake in France and Germany.

Low-Cost Developed Int'l ETFs Are Not Identical

Source: CFRA Research’s MarketScope Advisor, April 27, 2017

Meanwhile, the expense ratio for the Vanguard Growth Index ETF (VUG) also declined 2 basis points, and at 0.06%, is now closer to its peer, the iShares Core US Growth (IUSG). However, the indices and the resulting holdings of these products is distinct and impacting performance—VUG’s 12.0% year-to-date gain was ahead of IUSG’s 10.5%. The Vanguard offering has more consumer discretionary exposure (21% vs. 16%) and less industrials (8% vs. 12%), and the stocks chosen with these sectors are not identical.

For example, VUG owns Tesla, while IUSG does not, as the stock is not within the S&P index; (Vanguard Growth Index; Admiral (VIGAX) is also available for investors who prefer a mutual fund wrapper for 6 basis points).

Cheap Growth ETFs Constructed Differently

Source: CFRA Research’s MarketScope Advisor, April 27, 2017

The Importance Of The Big Picture

In ranking ETFs and mutual funds independently, CFRA Research combines holdings-level analysis with multiple fund attributes, including expense ratio and standard deviation.

The significance of understanding the holdings differences extends beyond equity products. The Vanguard Long-Term Bond (BLV) now costs 7 basis points and is 1 basis point cheaper than the iShares Core US 10+Year USD Bond (ILTB).

Yet the iShares product’s 3.42% total return year-to-date through April 27 was 29 basis points wider than BLV, highlighting the importance of what’s inside. ILTB has an approximately one-year lower duration, which will matter more than the higher fee if bond yields move higher. Conversely, it will hurt if rates do not move higher.

As more issuers move to lower fees in passive products, CFRA Research expects asset managers offering active alternatives will need to find ways to bring costs down. Because the case for charging 100 basis points or more than a Vanguard, iShares or Schwab product is dependent upon consistently outperforming—a task that’s hard for many to do.

But when choosing an ETF, fees are only one of the factors you should consider.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA.