The benefits of exchange-traded funds over the traditional mutual fund structure have driven the growth of these investment products over past decades. As adoption increases investors must be aware of the true cost of ETF investing. To facilitate this experts from Pershing and BNY Mellon have delivered a white paper outlining what investors need to assess when buying an ETF.
The true cost of ETF investing requires analysis of transaction costs and tracking error, not just fees.
“It is important for advisors to be as well informed as possible about the apparent and underlying factors that influence the cost of their ownership,” said Justin Fay, vice president and solutions manager for alternative investments and ETFs at Pershing. “Taking these factors into account will help advisors make a more accurate ‘apples-to-apples’ comparison, between ETFs, as well as between other investment options – such as low-cost mutual funds.”
Expense ratios are the most common means of assessing the cost of ETF ownership, and these are, on average, lower in ETFs than in mutual funds. One important reason for this, said Brian Brennan, Vice President of global ETF product management at BNY Mellon, is the creation and redemption mechanism unique to ETFs. “The cost of trading the underlying securities is borne by market makers who drive the primary trading of ETFs, rather than by the actual fund. Conversely, a mutual fund bears the costs of trading its underlying securities itself.”
Beyond expense ratios however there are a number of implicit costs which are often overlooked and need to assessed, such as bid-ask spreads. ETFs trade on exchange throughout the day with a bid price (the price that someone is willing to pay) and an ask price (the price at which a person is willing to sell). The difference between the two prices is the bid-ask spread and this needs to be understood and factored into a position’s cost.
The more frequently a particular ETF trades, the greater its potential liquidity. This causes the bid-ask spread to narrow and lowers the cost of the trade. Conversely, the less frequently a particular ETF trades, the wider the theoretical bid-ask spread, making it more expensive to transact due to fewer buyers and sellers. Careful attention should be paid to the spread on commission-free ETFs, which may have bid-ask spreads so wide that the benefit of paying no commission is outweighed.
Lastly, a fund’s tracking error needs to be assessed to determine how closely an ETFs price mirrors its benchmark. Ultimately any diversion from the index return needs to be considered a cost to the ETF holder and a higher tracking error means a higher risk that this can occur. Determinants of tracking error can include how closely the fund replicates the underlying holdings of the index and trading efficiency.
“Foreign and emerging markets are especially prone,” said JC Mas, Managing Director and head of ETF and portfolio trading at BNY Mellon Capital Markets. “Establishing the fair value of emerging market ETFs that trade in North American time zones is difficult due to the fact that trading often occurs when overseas markets are dark. This means that the arbitrage mechanism that governs all ETFs is far more subjective than other (often mathematically exact) pricing usually observed in ETFs with domestic components.” As a result, traders must estimate fair market value, which can increase the risk that investors will buy at significant premiums or discounts.