Journal of Financial Planning: January 2014
Matt Hougan is president of ETF Analytics and global head of editorial for IndexUniverse, where he oversees content and spearheads its efforts to reshape the way investors analyze ETFs.
According to a study by Charles Schwab, expense ratios are the No. 1 factor investors consider when deciding which ETFs to buy. The study is self-serving (Schwab’s ETFs are the lowest priced on the market); nonetheless, I think it’s true. Ask a dozen investors what is the first thing they look at when evaluating an ETF, and I’d guess a strong majority would say “fees.”
It shouldn’t be that way. Expense ratios do matter, but in the grand scheme of things—particularly as you look at non-standard ETFs—they matter a lot less than you think.
Understanding Tracking Difference
The problem with expense ratios is that they only tell part of the story. Actively managed ETFs aside, the goal of most ETFs is to track an index. Expense ratios obviously play a critical factor in the ability of ETFs to do that, but they are not the only factor. The quality of the fund’s management and the efficiency of its strategy matter, too. ETFs can be easy to manage against an index, or difficult. They can hold liquid stocks and never rebalance, or illiquid stocks and trade all the time. They can have world-class index managers or average punters asleep at the switch. And the impact of all this can be startling.
Consider the five broad-based emerging markets ETFs in the table. The tracking difference is a measure we calculate at IndexUniverse that looks at how much each ETF lags its index, on average, over a given one-year period. We compare each ETF’s performance with its own benchmark over 252 one-year time periods (a rolling two-year window). The median result gives us a sense of the average experience an investor has had in the fund.
All these ETFs look cheap from an expense ratio perspective. But the tracking difference shows a different story. The Vanguard ETF does well, trailing its benchmark on average by 0.26 percent. The iShares Emerging Markets Low Volatility ETF (EEMV) looks even cheaper, performing better than its expense ratio and lagging its index by just 0.19 percent.
Equal-Weighted Strategies
The real story comes when you look down the table at funds like the Guggenheim MSCI Emerging Markets Equal Weight ETF (EWEM). Instead of weighting securities by market cap, equal-weighted strategies invest an equal amount in each security in an index. That’s interesting in emerging markets, where large multinationals like Taiwan Semiconductor and Petrobras dominate the index.
An equal-weighted strategy like EWEM will invest the same amount in Eclat Textile Co. as it invests in Petrobras. That offers more exposure to companies servicing local demand in emerging economies, which may be more appealing and offer a better diversification benefit than traditional funds targeting the large multinationals.
But this small cap tilt, and the fact that the fund rebalances each quarter, selling all its winners and buying its losers, comes at a cost that is not reflected fully in the 0.70 percent expense ratio. Instead, in an average year, EWEM has trailed its benchmark by more than 3 percent.
The equal-weighting strategy has appeal, and you may think it’s worth it if it only costs 0.52 percent more than the vanilla Vanguard product. But 3 percent per year? That’s a mighty big hurdle to fly over just to break even.
Expense ratios are still important. But at least in sticky areas like emerging markets—particularly with more sophisticated strategies—tracking difference is a much more important statistic.
It’s not what you pay, it’s what you get that matters.