It’s a refrain we repeat often at State Street Global Advisors and during meetings with clients: when selecting an ETF, you need to look beyond the expense ratio to assess a fund’s total cost of ownership. Why? Because using the expense ratio as the sole factor when selecting an ETF without considering additional variables, especially how you will invest and trade that fund, could wind up costing you more money in the long run.

ETFs: An expense ratio doesn’t capture the full cost story

It’s not surprising that in today’s low-growth environment, expenses are top of mind. Many investors focus on a fund’s expense ratio to determine if it is “low cost.” But, as illustrated below, the expense ratio captures just one important part of the total cost of ownership equation. While expense ratio is an important part of the equation, it is essential to evaluate other costs associated with an ETF investment.

Source: State Street Global Advisors

Let’s deconstruct these costs, one variable at a time:

  • Expense Ratio. The expense ratio represents the portion of your investment that the fund charges on an annual basis for management fees. All else being equal, lower expense ratios are positive for investors. Because ETF expense ratios are already low across many categories, savings generated by a reduction in fees can be offset by other variables such as wide bid/ask spreads and trading commission.
  • Commissions. Trading commissions, like expense ratios, have also compressed over time due to competitive forces. Some wealth management platforms now offer certain ETFs to trade for free. But a high expense ratio or a wide bid/ask spread can cost you more than what you would save on commissions over the life of your investment. Given this, commissions are an important factor to consider when conducting ETF diligence.
  • Bid/ask Spreads. The difference between the price a buyer is willing to pay for shares and the price at which a seller will sell is known as the “bid/ask spread.” The width of the bid/ask spread for any ETF is driven by several factors including the ETF’s trading volume and the liquidity profile of the underlying securities. ETFs with lower exchange trading volumes tend to have wider spreads, however, this does not tell a complete story about an ETF’s liquidity profile. As an ETF’s trading volume increases, so does its profile in the market, attracting a broader range of investors, traders and liquidity providers. This increased competition leads to tighter bid/ask spreads, therefore, making trading more cost-effective.

When evaluating an ETF, consider your time horizon

One question you should ask yourself before selecting a fund is how you will be investing and using the ETF you are evaluating. The ETF that best meets your needs may depend on whether you intend to hold it for a short or long term.

If an investor expects to trade frequently to better manage exposures within a portfolio, execution costs—like spreads and commission—may be the prevailing factor for total-cost-of-ownership consideration. Alternatively, in instances where a buy-and-hold ETF strategy is being implemented, for example in the core of a portfolio, the management fee that an investor must pay year-after-year may be the prevailing factor for total-cost-of-ownership consideration.

As the chart below demonstrates, execution cost (inclusive of spread and commissions) will be the more relevant consideration for day traders. For buy-and-hold investors, the management fee may be the more relevant metric.

Source: State Street Global Advisors

Why an ETF’s total cost does matter

At State Street, total cost of ownership has long been a key part of the value we offer investors, providing perspectives on how to perform due diligence on individual products, including our own. It’s also a topic that I’ve discussed since helping to launch the first US-listed ETF in 1993—and one that I’ve addressed on SPDR Blog in the past.

The bottom line is that costs do matter; selecting an ETF that winds up being more costly than expected can erode a portfolio’s total return. That is why it is crucial to go beyond the expense ratio to evaluate an ETF’s total cost of ownership and examine commissions and bid/ask spreads. If you put too much focus on any one factor, such as expense ratio, you may miss out on valuable information and wind up paying more for the security in the end.

To help you choose the right fund to meet your investment needs, our ETF Due Diligence Checklist can guide you in a comprehensive evaluation of ETFs.

Definition

Bid/Ask Spread
The difference between the highest price a buyer is willing to pay for an asset and the lowest price the seller will accept. Bid/ask spreads are a key measure of the liquidity of an asset or security.

Expense Ratio
The portion of your investment that the fund charges on an annual basis for management fees—from trading and marketing expenses to custodial and index licensing fees.

S&P 500 Index
The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.

Tracking Error
Tracking error is a measure of how consistent a portfolio’s return is with that of its benchmark. In reality, no indexing strategy can perfectly match the performance of the index or benchmark, and the tracking error quantifies the degree to which the strategy differed from the index or benchmark, by measuring the standard deviation between the two values, annualized.

Market Maker
A financial firm, usually a broker-dealer that is charged with facilitating trading in a particular security. Market makers are typically large financial intuitions with considerable market buying power in secondary securities markets.