The True Costs of ETF Ownership

The True Costs of ETF Ownership

Exchange-traded funds have rock-bottom expense ratios, but those aren’t the only fees.

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Reviewed by: Lisa Barr
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Edited by: Sean Allocca

One of the critical factors in successful investing is minimizing costs. Though many exchange-traded funds fulfill this goal with rock-bottom annual expense ratios, there are also other costs. And while commissions are becoming extinct, there are still trading costs; namely, bid/ask spreads, and premiums and discounts over net asset value.  

A recent Vanguard Group Inc. piece titled “Discover the deeper importance of low ETF expense ratios” examines the total cost of ownership. The authors, David Sharp and Patrick Hooper, note the importance of the three expenses examined are dependent on the holding period.  

That’s because the spread and potential impact of premiums and discounts are paid only when buying and later selling, while the expense ratios take from returns daily. Vanguard offers the following framework: 

Importance of Fees are Dependent on Holding Periods 

As one example, the paper compares the largest ETF, the SPDR S&P 500 ETF Trust (SPY) to the Vanguard 500 Index Fund (VOO). The paper notes that SPY has a much smaller spread (0.0039% vs. 0.0083%) but a higher annual expense ratio (0.0945% vs. 0.03%).  

It calculates that SPY has a lower total cost of ownership for up to 26 calendar days, with VOO prevailing for longer periods. The etf.com comparison tool shows the spreads and expense ratios for these ETFs as well as others.  Not surprisingly, the tool indicates VOO bested the SPY by 6 bps annually over 10 years.  

I spoke to William Coleman, Vanguard’s head of U.S. ETF Capital Markets, about the study. He stated that premiums and discounts versus NAV were not included in the calculations, as they tend to average out over time. I pointed out that on March 12, 2020, many bond ETFs traded far below NAV. Coleman responded that in volatile markets, we encourage fixed income investors to stay focused on their investment goals and avoid trading, if possible, until markets stabilize. 

Comparing the Best ETFs 

It’s not exactly shocking that SPY is a better trading tool, while VOO is the better investing tool. Vanguard estimates that over a 10-year period, a $100,000 investment in SPY would cost $949, while VOO would be less than a third, at $308.  

Since I believe that broader is better, I decided to compare the three broadest categories of total index funds, using products of the two ETF giants, iShares and Vanguard. These include a total U.S. stock index fund, a total international stock index fund and a total bond index fund. Unlike the previous comparison of S&P 500 index funds, these two brands follow slightly different indexes.  

I turned to Elisabeth Kashner, VP, director of global fund analytics at FactSet Research Systems, to calculate annualized costs over a decade.  

 

 

Conclusion 

Not surprisingly, all three comparisons were essentially a tie. Kashner stated that “anyone who makes a decision to purchase a fund based on total cost differential of less than 1 bp is missing the forest for the trees.” But she noted that “when it comes to larger differentials in ETFs, remember that lowering total cost of ownership frees up cash you can invest for your future.”  

Also, Coleman stated: “We typically achieve midpoint pricing on more than 95% of Vanguard ETF trades on our brokerage platform.” 

While iShares had a slightly lower 10-year cost of ownership, I give a slight edge to the Vanguard ETFs for two reasons. First, while both return some fees from profits in securities lending, Vanguard states it returns 100% of the profits to shareholders, while iShares returns about 81% to 82% to shareholders. Second, and most importantly, the Vanguard ETFs are broader, with far more holdings.  

Irrespective of which of these outstanding ETFs you use, remember to always use limit orders when trading them. You don’t want to be subject to either increasing spreads or market movements such as the 2010 flash crash, where a market order to sell could have produced disastrous results.  

I typically recommend buying with limit orders, with a limit no more than a few pennies higher than current market, and selling with a limit no more than a few pennies lower. Chances are extremely strong that it will execute at the current market, but you protect yourself from wild swings. 

Let me close with a few words of advice: Don’t trade in the early morning. Never put in an order after the market has closed, as it will likely execute first thing when the market opens and spreads are the largest. It also subjects you to market changes due to news released before the market opens. And finally, try to keep diversification high and expenses low. 

Allan Roth is founder of Wealth Logic, an hourly based financial planning and investment advisory firm. He also benchmarks portfolio performance for foundations and other business concerns. Roth's website is www.DareToBeDull.com. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter