Expense Ratios Don’t Matter In ETFs

This article was originally published on ETF.com

The first statistic investors look at when evaluating ETFs is the expense ratio. It’s also sometimes the least important. ETFs are famous for being low cost, and there’s been a spectacular race to the bottom on fees in ETFs. The game seems to be, How low can you go? The answer is very, very low.

You can now buy complete U.S. equity exposure for just a 0.04 percent annual expense ratio, with the Schwab U.S. Broad Market ETF (SCHB | A-100). You can buy emerging market exposure for a shocking 0.14 percent, with the Schwab Emerging Markets Equity ETF (SCHE | C-88).

Vanguard, iShares and others have amazingly low sticker prices too, driving the game every lower. I wrote about this recently in my blog, the Cheapest ETF Portfolio Just Got Cheaper.

But here’s the thing: None of this actually matters.

Or at least, it doesn’t matter as much as people think. That’s because, with ETFs, as with everything else, what matters most is not what you pay but what you get. And those two things can be very different.

Here’s what I mean. Consider two emerging markets ETFs: the aforementioned SCHE and the iShares Core MSCI Emerging Markets ETF (IEMG | B-98). On a headline basis, the two charge similar fees, with SCHE looking slightly cheaper:

• SCHE: 0.14 percent expense ratio
• IEMG: 0.18 percent expense ratio

If you were a naive investor, you might expect at the end of the year for each fund to trail its index by its expense ratio.

We monitor these funds (and all ETFs) closely at ETF.com, and one of the primary things we look at is how well these funds track their indexes. Specifically, we look at how far off its index each of these funds is over any given one-year period.

If you look at two years of data (or 252 one-year periods), the median result is as follows:

• SCHE: -0.44 percent behind its index
• IEMG: +0.07 percent ahead of its index

Excuse me?

This real-world result comes from the inherent messiness of running an index fund. However exact you make the science, there are ways to both add value to and detract value from your efforts. These include:

Trading Costs (Always Negative): Between index rebalances, index changes, equitizing dividend income or putting cash to work, there can be inherent slippage when execution trades. These can be de minimis in a large-cap U.S. equity fund tracking a market-cap-weighted index that handles all new money with in-kind creations, or it can be very significant in an equal-weighted strategy focused on emerging market small-caps.

Sampling (Positive or Negative): ETF managers do not always buy all the securities in an index. If you have an index tracking 5,000 securities, the ETF manager might only buy 3,000 securities, or even just a few hundred. He or she will use complex software to identify securities that should mimic the returns of the index. But no matter how good the model, it’s never perfect. Sometimes they win, sometimes they lose.

Securities Lending (Typically Positive, Rarely Negative): Many index funds and ETFs that hold securities lend them out to short-sellers. In exchange, short-sellers pay a fee to borrow those securities. The fund or ETF also gets collateral it they can invest in short-term securities, earning (a little) interest. Combined, these can create a nice tail wind to a fund’s returns. In extraordinarily rare cases, things can go wrong, and the fund can lose a bit of money by having to claim that collateral and buy back securities.

These two ETFs landed on different sides of this equation for the time period we studied. SCHE optimizes—it holds 666 of the 740 stocks in its index—and that optimization cost it over the two-year period we studied. It could have gone the other way, but it didn’t in this case. It’s worth noting that SCHE’s tracking has improved dramatically in recent months, and it now tracks very tightly.

IEMG, on the other hand, is unique for two reasons: First, unlike most emerging market ETFs, it holds small-cap securities. Second, it engages in aggressive securities lending, which generates significant income for the fund. As a result, it was able to actually outperform its index. It’s like getting paid a bonus for choosing emerging markets exposure, rather than paying the manager at all.

Expense ratios are still important. They are a fixed cost, while tracking difference can be variable. But at the end of the day, what matters most is what you get, and expense ratios are just one piece of that pie.

At the time this article was written, the author held a position in IEMG. Contact Matt Hougan at [email protected].