Beyond the headline fee
Investors must look beyond the headline fee when investing in ETFs and consider the total cost of ownership.
Investors can break down the total cost of an ETF into the total expense ratio (TER) and transaction costs like bid-ask spreads.
The TER is an annual headline fee, a continuous cost that accrues as long as an investor holds an ETF.
ETFs that track broad market-cap-weighted indices such as the S&P 500 typically have lower fees than exotic exposures which command higher TERs. The more active the ETF, the higher the fee typically is as well.
In contrast, fees from bid-ask spreads occur at the point when an investor is buying or selling an ETF.
ETFs have a bid-ask spread which reflects the costs the authorised participants (APs) pay in the primary market to create and redeem the ETF.
This spread is the difference between the highest price a buyer is ready to pay and the lowest price a seller is willing to accept.
Bid-ask spreads are affected by several factors:
The ETF's trading volume or turnover plays a role, with lower volume typically leading to wider spreads
The volatility of the ETF’s underlying securities can impact the spread, especially during periods of market stress
The liquidity of these underlying securities is crucial as illiquidity tends to generate wider bid-ask spreads, especially when an ETF’s volume is lower
Volatility widens spreads
Market makers – which provide liquidity by buying from one client and selling to another – also influence the spread. For ETFs with high turnover in the secondary market, market makers can afford narrower spreads due to reduced market-movement risk. Conversely, ETFs with lower turnover face wider spreads to compensate for the increased risk and holding costs of the securities.
Beyond the TER
On top of this, heightened market volatility can lead to wider spreads as market makers adjust their bids and offers to mitigate potential losses. These factors, though impactful, often play second fiddle to the TER in terms of their overall effect. Additionally, investors should be mindful of the timing of their trades. Avoiding trading in the first minutes of a trading session or around major market-moving news can result in tighter spreads and more predictable trade executions. An example would be trading when a central bank announces changes to interest rates.
Securities lending
Finally, investors should consider whether an ETF is engaging in securities lending – lending out the underlying securities in exchange for a fee – which can reduce the total cost of ownership.
Key takeaways
Do not just focus on the advertised expense ratio. Include bid-ask spreads, which vary based on trading volume, volatility and market makers.
While spreads can impact costs, the TER is usually more significant. Consider timing your trades for tighter spreads.
Explore ETFs engaging in securities lending for potential fee reduction. Remember, total cost of ownership matters.
