Look Beyond Fees When Picking ETFs

(Inside ETFs kicks off its flagship conference in Florida on Sunday, Jan. 21. CFRA will be sharing insight during the "ETFs 101: How ETFs Work & How to Pick the Best ETF Every Time" session. For those unable attend, we wanted to share some of the work we aim to present.)

When choosing an ETF, the expense ratio is the starting point for many investors and advisors. Asset managers are bringing down fees in hopes of getting a larger piece of the growing ETF pie. However, we caution investors from focusing solely on buying the cheapest fund.

In December, a survey of advisors conducted by ETF.com/BBH revealed that 64% of respondents deemed an ETF's expense ratio as very important when sorting through the choices. In his related article on the survey results, ETF.com's CEO Dave Nadig shared that 53% of advisors said the primary reason they focus on cost is because they have a fiduciary obligation to their clients.

In a few cases, the expense ratio should be the primary metric for an advisor choosing an ETF.

For example, in 2017, the Vanguard S&P 500 Index ETF (VOO) rose 21.77%, 7 basis points stronger than peer SPDR S&P 500 ETF Trust (SPY). While both ETFs trade with a penny bid/ask spread, VOO's expense ratio is 0.04%, lower than the 0.09% for SPY. Investors seeking S&P 500 index exposure should pay as a little as possible.

Similarly, there are multiple ETFs that track the prominent Russell 1000 or Bloomberg Barclays Aggregate indices. When comparing two different ETFs that track the same index, generally it is good advice to buy the one with the smaller expense ratio.

Going Beyond Fees

While CFRA incorporates a fund's expense ratio in our forward-looking rating of more than 1,300 ETFs, we think the performance gap between two ETFs will often be much greater than the high-profile fee differential.

For example, it is easy to think that buying the cheaper of two popular small-cap ETFs would be the way to go. In 2017, the Vanguard Small-Cap ETF (VB), which charges a 0.06% expense ratio, rose 16%, outperforming the 13% total return for peer iShares Core S&P Small Cap (IJR).

But the performance gap significantly outweighs the 1 basis point savings investors in VB receive. Moreover, one year earlier, in 2016, IJR was the stronger performer, outpacing VB by 800 basis points, serving as a reminder not to rely on past performance success with an ETF.

Importance Of Indices
Although both ETFs focus on the small-cap space, they track two very different indices. With ETFs that track different indices, investors need to go beyond expense ratio.

From a sector perspective, VB has more in information technology stocks (17% of assets vs. 14% for IJR) and less in consumer discretionary (11% vs. 15%). VB also has more than double the number of stocks in the portfolio.

Turning to emerging markets, it's notable that both iShares and Vanguard offer emerging market ETFs with net expense ratios of 0.14%, yet they perform and are constructed very differently.

The iShares Core MSCI Emerging Markets ETF (IEMG) rose 37% in 2017, outperforming the 31% return for the Vanguard FTSE Emerging Markets (VWO). The performance differential results in part from what the underlying benchmark index considers an emerging market.

IEMG recently had a 15% weighting in South Korea stocks, including Samsung Electronics, while VWO has no exposure to the country. MSCI classifies South Korea as an emerging market, while FTSE Russell views the country as a developed market. In contrast, VWO has more exposure to India (12% of assets vs. 9% for IEMG). Both have more exposure to China than other countries.

Conclusion

CFRA has research on 281 ETFs that have a gross expense ratio of 0.20% or less, 52 of them that launched in the last three years. Deutsche Bank, Fidelity, Goldman Sachs, iShares, PowerShares, SSGA, Vanguard and WisdomTree are among the asset managers with such recent launches.

As advisors consider low-cost ETFs, take a deeper dive into what's inside and what will drive future performance.

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.