The cost of trading an ETF goes beyond expense ratios, and in the case of hedge funds and institutions, that’s especially true.
[This article first appeared on IndexUniverse.com and is republished here with permission.]
In a blog last week, I explored the positions two high-profile hedge fund managers, John Paulson and George Soros, are taking in the SPDR Gold Shares (NYSEArca: GLD), the huge gold ETF.
In that piece, I compared the round-trip cost over the course of a year of buying, holding and selling GLD with the cost of the iShares Gold Trust (NYSEArca: IAU). I stand by this analysis as it relates to retail investors.
After all, the average spreads and expense ratio figures I quoted are indisputable. Those are the round-trip costs a retail investor is likely to have to pay in buying and selling the funds.
Different Investors, Different Costs
The problem is I used two institutional investors to make my case. As I attempted to touch on, liquidity means different things to different investors. For example, when I stated that the two funds are similarly liquid, that only holds true for retail investors.
Sure, the average bid/ask spread for IAU is 0.06 percent compared with 0.01 percent or less for GLD, but the difference in share price plays a big role in that. After all, a penny spread on GLD—a $160-a-share ETF—is significantly smaller on a percentage basis than a penny spread on IAU, a $16-a-share ETF.
And that leads me into my next point: Because GLD represents a 10th of an ounce of gold compared with 1/100 of an ounce for IAU, we must use the notional value of a position to compare apples with apples. And this is where new frictions come into play for institutional investors like Paulson and Soros.
When big players are trading 25,000 shares or more of an ETF, or buying and selling block-sized trades, they have to work orders with broker-dealers to ensure optimal pricing. These broker-dealers may be nice folks, but they don’t do their jobs for free.
In fact, the going rate for their services is usually about a penny a share. Since IAU is one-tenth the price of GLD, the cost of trading IAU will be significantly higher for the institutional investors in question. Take the following example where one investor trades $1 million in notional value of both GLD and IAU.
As you can see, the round-trip cost for institutions trading GLD is more than 6 basis points cheaper than IAU on the same notional value. In that way, the higher share price of GLD is a benefit to institutional investors because the share count required to get the same notional exposure is one-tenth that of IAU.
So it follows that the commission expense on the same notional value for IAU is 10 times that of GLD.
This concept of notional value is relevant in more ways than one. Many institutions—and I’m assuming Paulson and Soros fit in this group—use derivatives to either hedge or enhance their positions in ETFs like GLD or IAU.