Hidden Fees Content provided by Paula Wieck, CLS Manager of Investment Research One of the first things investors ask before buying a fund is, “What does it cost?”  They diligently look up the expense ratio on a popular financial website such as Morningstar or Yahoo Finance and make their decision. The problem is that the cost of an ETF is much more than just the expense ratio. What are the other costs and how can we quantify them? Morningstar has a number of proprietary data points which we monitor on a daily basis in our ETF Shopping List. While the expense ratio is an important statistic, there are more data points that go into our cost analysis of owning and trading an ETF. Here is an example to help explain. Let’s say we want to purchase an S&P 500 ETF. Below are some of the more popular S&P 500 (or similar) ETFs and their corresponding expense ratios to choose from:

 paula chart 1

Data from Morningstar as of May 25, 2012

If we were looking at the expense ratio alone, it seems like a no-brainer!  VOO clearly has the lowest expense ratio. But is it the really the cheapest?  The answer is…it depends! It depends on what your goal is for the position. Do you plan on holding it for a long time or do you plan on tactically trading in and out of it?  If you plan on trading frequently, it may actually be more prudent to own SPY, as SPY has the lowest Market Impact Cost. Paula chart 2 According to Morningstar, the “Market Impact Cost represents the average market price movement in percent, caused by a $100,000 trade in the ETF.”1  If an ETF’s market price tracks its Net Asset Value (NAV), it is likely to have a small market impact. On the other hand, if the market price is more volatile than the fund’s NAV, a larger order could move the price before a market maker would be willing to step in and close that gap, leading to higher market impact costs. In other words, the larger, more heavily traded the fund, and the more liquid the underlying securities, the lower the Market Impact Cost is likely to be. On the contrary, if one’s intention was to hold the ETF for a longer time frame, SPY wouldn’t necessarily be the best choice. One should look at the Estimated Holding Cost of the ETF as well. In this case, VOO looks the cheapest. Morningstar’s proprietary Estimated Holding Cost represents the realized cost of replicating an index. If the cost is small, or even negative, it indicates the ETF is doing a better job matching or beating its index while minimizing costs. In our example above, even though SPY has the lowest Market Impact Cost, it has the highest Estimated Holding Cost due to the structure of the ETF. SPY was the first U.S. ETF and was structured as a Unit Investment Trust (UIT), and this structure is prohibited from engaging in share lending, reinvesting in dividends, and holding securities outside of the index, these factors making it much more difficult to minimize index replication costs. IVV, VOO, and SCHX are structured as regulated investment companies and can engage in share lending, reinvesting dividends, and have more freedom to optimize portfolio holdings to match the index efficiently. At CLS, our investment team is constantly analyzing every ETF we own compared to the ETFs that are available within the ETF universe. With so many ETFs coming into the space that are similar, these types of data points allow us to make an educated decision as to deciding – “is that really the best ETF?”

[1] Paul Justice and Michael Rawson, “ETF Total Cost Analysis in Action,” Morningstar ETF Research, June 2012.
An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket. The primary diversifiable risk is business risk. Other diversifiable risks may apply based on the assets which the ETF invests in.
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