3 Considerations Before Switching To ‘Cheaper’ ETFs

Exchange-traded funds have democratized access to just about every corner of the market. They also have fostered an unprecedented focus on costs over the years, and fueled fee compression across the investment industry.

It’s common to hear of ETF issuers slashing price tags in an effort to compete for investor dollars. But is cheaper always better? Should you always opt for the cheapest ETF in class?

The answer is, not necessarily.

Cheaper May Not Be Better

Costs are possibly the only metric you can fully control in an investment decision. And the less you pay for a fund, the more you keep in your pocket—that will always be true.

Still, if you are considering jumping from one ETF to another based on lower fees alone, or picking an ETF solely based on expense ratios, you might want to take pause.

When it comes to investing in ETFs, there are three key considerations you should make about a strategy. They are efficiency, tradability and fit. Those three factors power FactSet’s ETF ratings on ETF.com.

The Fit

“Most investors should probably consider fit first,” said Dave Nadig, director of ETFs for FactSet. “You can have a 10% surprise in your performance by being in the wrong index, versus maybe a 1% surprise by being in the wrong ETF tracking the same index.”

In other words, your first consideration for any ETF is the underlying exposure, and how that underlying exposure fits into your broader investment portfolio and goal.

“Switching from, say, an actively managed large-cap equity fund to a total-market ETF is in fact a pretty big shift in your overall exposure, regardless of cost,” Nadig said.

An example here would be the decision to own the Schwab Emerging Markets Equity ETF (SCHE | B-95) for broad emerging market equity exposure versus, say, the iShares Core MSCI Emerging Markets ETF (IEMG | A-99) based solely on the fact that it’s the cheapest in its segment at 0.14% in expense ratio. IEMG costs 0.16%.

SCHE tracks the FTSE Emerging Market Index, which excludes South Korea. FTSE doesn’t consider South Korea an emerging market, as does MSCI—the benchmark provider underlying IEMG. Depending on your view on South Korea, and how you want to allocate to that country, SCHE might not be the best fit for your portfolio despite the cheaper price tag.

A decision between these two funds would overlook an important exposure if it were based on cost alone. South Korea represents roughly 15% of IEMG.

The Efficiency

The efficiency of a fund is measured by looking at a few different metrics that together assess the overall costs of owning a fund. These costs include expense ratios, for sure, but also take into account tax implications and tracking differences—how well an ETF tracks its underlying index.

“There are plenty of examples of funds that are the ‘cheapest’ in the segment but aren’t actually consistently the cheapest to own,” Nadig said.

Consider the Schwab International Equity ETF (SCHF | A-95). The fund is the cheapest in the developed market ex-U.S. segment at 0.08% in expense ratio. And as Nadig put it, it’s “fantastically managed,” showing median tracking difference over 12 months of just -0.01%.

“You’re basically getting almost all of those 8 basis points back in good management and securities lending,” Nadig said.

But the more expensive iShares Core MSCI EAFE ETF (IEFA | A-95), which costs 0.12% in expense ratio—or 50% more than SCHF—has a positive median tracking difference of 0.08%. In other words, returns of the fund’s net asset value are consistently above those of the underlying index. “You get paid to hold it,” noted Nadig.

Again, based on efficiency alone, cheaper on the surface—based on expense ratio alone—isn’t necessarily so, even among two stellar funds.

The Tradability

Finally, there’s tradability. How well an ETF trades is crucial to how much you end up paying to own the fund. Trading costs can sneak up on an unsuspecting investor who isn’t paying attention.

“If you’re only holding an ETF for a year, the difference in spreads could be all the difference,” Nadig said of trading costs.

To go back to IEFA, FactSet gives the fund a tradability score of 89, while its larger and more expensive in-house competitor, the iShares MSCI EAFE ETF (EFA | A-91), gets a 92. These scores represent just how easy—or not—it is to trade 15,000 shares of the funds.

IEFA, which has $11.5 billion in assets, and sees about 2.5 million shares trade hands on average every day, trades with an average daily spread of 0.02%. That’s an added cost to investors of about $2 per $10,000 invested a year.

The fund has also traded in the past 12 months with a median premium over its fair price, or net asset value, of 0.23%. By comparison, EFA, which has $56.4 billion in assets, has traded with a median premium of 0.08% in the same period, according to FactSet data. EFA also trades with an average daily spread of 0.02%.

In the end, EFA has an expense ratio of 0.33%, or more than twice IEFA’s price tag, but the fund has some cost benefits in tradability that shouldn't be overlooked.

The Final Score

These key metrics offer you a more comprehensive look of the ETF you are buying—not only what it owns, but how well it trades and how it fits into the mix relative to others in the same segment.

Fee compression and lower expense ratios are great, but they hardly tell the whole story.

Contact Cinthia Murphy at [email protected].