What Is the Total Cost Of Ownership For An ETF?

Passives funds and in particular ETFs have seen a significant growth in their use over the last 10 years, and this trend looks to continue with growth of FUM in ETFs globally of 7 percent in 2015 so far.

The question of whether a passive investment style should be followed is one of the main decisions an adviser will make with their client. Often this decision is made along investment philosophy lines and with a consideration of fund fees vs. that of an active manager outperforming. However, this doesn’t include all the potential costs of an ETF, and when combined with clients regularly not having a complete understanding of how an ETF is constructed, this decision may be made with an incomplete picture in mind.

ETF Structure

ETFs are similar in construction to investment trusts in that they are closed-ended, set up with an fixed amount of capital and listed on an exchange, for example the London Stock Exchange. Similarly, the price at which an ETF trades may differ from its underlying Net Asset Value (NAV) due to short-term supply/demand issues. A premium or discount may exist, depending on if the ETF price is above or below the NAV.

The key difference between ETFs and an investment trust is that an ETF has multiple ‘authorised participants’ who effectively act to keep the ETF price equal with its NAV. The authorised participants are other large investment firms or banks, and are allowed to trade the underlying securities in the ETF against the market price. If there is a deviation between the NAV and the ETF market price, an arbitrage is possible for the authorised participant to make risk-free returns. This in turn ensures the ETF price follows the underlying NAV very closely.

NAV Premiums + Discounts

There have been some instances where the price for an ETF has moved away from the underlying NAV. This can occur in more illiquid markets or during times of market panic. Another reason this can occur is when an ETF trading in London tracks an overseas index, for example Japanese equities. In this case the ETF can be trading in London while the relevant exchange is closed in Japan due to time differences. Hence the underlying securities in the index will not be available to ensure the NAV is closely aligned with the ETF price.

Despite these situations, it should be noted that these premiums or discounts are short lived compared with investment trusts.

In addition, we can compare an ETF’s structure with that of a passive Open Ended Investment Company (OEIC). With an OEIC, the price of the fund is set by the underlying assets so there is never a premium or discount. However, the downside to this is that trading only occurs once per day at a ‘valuation point’, usually 12pm each day. This means that an investor will not know in advance the exact price they will receive for their fund units. Again, during times of market panic or in illiquid markets, the difference in listed price and actual price received by the investor can be large.

Other Costs And Benefits?

There are a handful of other features that an ETF investor should consider:

Bid/offer spread:

Similar to buying any stock on an exchange, there is a buying price and a selling price for each ETF unit. This spread will be smaller for more frequently traded ETFs and those tracking large liquid indexes. This spread should be taken into account as a cost when making the initial investment.

Stamp duty:

Mentioned here as some investors may believe they need to pay stamp duty if the ETF is traded on the London Stock Exchange. However, this is not true and no stamp duty is payable. This originally only covered those ETFs domiciled abroad (which is the majority of London listed ETFs), but since April 2014, the Chancellor has removed the stamp duty requirement from UK-domiciled ETFs as well.

Stock lending:

Due to the structure of an ETF, the provider of ETF units can generate extra revenue by lending out the underlying securities of the ETF on a short-term basis. This may seem like a negative for an ETF investor, however, due to the competitive market for ETF fees, an ETF provider will use this revenue to lower the cost of the ETF.

Broking fee:

Also important to bear in mind is the fee the investor will pay depending on how they invest in their ETF. There are different share trading and funds platforms, all of which have different trading fees and annual expense costs. The investor should consider the amount they have to invest and how often they are likely to be trading over the course of a year.

Jason Baran is insight analyst (investments) at Defaqto

[This article was first published on Defaqto’s adviser newsletter and has been republished with permission]