Comparing Costs And Counterparty Risk

August 04, 2008

Tracking down the real costs to investors in exchange-traded products.



An interesting article[1] in the most recent iShares monthly newsletter caught my attention. Its authors make the point that comparing ETFs and ETNs or ETCs simply on the basis of the total expense ratio may not give a true picture of the real cost to an investor when choosing a particular tracker.

The iShares authors suggest paying attention to various additional factors when evaluating exchange-traded securities, and in particular:

  • Trading costs—bid/offer spreads and brokerage commissions
  • Rebalance costs—from the inflow and outflow of securities during regular rebalancings of the underlying index
  • Lending revenues earned or foregone—from securities lending within an ETF, and from lending of the ETF units themselves

These costs can all be quantified, more or less. Trading costs can be measured by looking at the liquidity of the assets underlying the exchange-traded security, and most leading European exchanges publish data showing historical ETF bid/offer spreads in standardised trading sizes.

Rebalance costs are harder to quantify, but one can look at the stability of different versions of indexes and estimate how many index components are likely to change, how frequently and what the likely cost is. Clearly, some indexes are likely to change composition to a greater extent than others—market-cap-weighted indexes tend to have lower turnover than indexes with alternative and/or equal-weighting structures.

In addition, potential ETF lending revenues—which would reduce the cost of ownership to an investor—can be assessed by comparing issuers' policies on sharing revenues with investors from lending within their funds, as well as by checking the likely returns to be generated from lending the ETF units themselves (if you are an institutional investor).

A typical calculation might run something like this, according to the iShares report.



Table: Lending Revenues Calculation
 Source: BGI - for illustrative purposes only



In other words, a difference in the headline total expense ratio between two ETFs may easily be compensated for by differences in the three other factors mentioned above. In the given example, ETF 1 has a higher total expense ratio than ETF 2, but makes up for it via lower trading costs and greater stock lending revenues.

This all seems valid stuff, and is certainly helpful advice for an investor, even if it means that making a sensible choice about the right fund is going to mean some digging around for information.

But that's not the end of it. Further cost differences are implicit in the differing varieties of ETF themselves, and between ETFs and other exchange-traded securities such as ETNs and ETCs. To get an idea of what these might be, let's look at another table from the iShares report.


Table: cost differences between ETFs ETNS ETCs

  *Swap-based ETFs generally require all Primary Market trades to be routed to one internally designated swap counterparty.

**If the ETF tracks a Price Return Index, the dividends will be periodically distributed. If the ETF tracks a Total Return Index, the dividends will be reinvested.


There are various additional and quite subtle differences, all affecting an investor's potential "value" from an ETF/ETC/ETN, that could be highlighted here - from UCITS compliance or noncompliance, to the number and depth of authorised participant relationships, to dividend reinvestment or distribution policies.

But one line in the table does stand out as a real, and also a quantifiable, additional cost: Counterparty risk. And, as we will see below, the market is currently telling us that this cost is potentially a multiple of those we discussed earlier.


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