Costs don't stop at the expense ratio.
In the investment process, once a high-level investment thesis or allocation decision has been made, the question shifts to how one can best gain exposure. While there are certainly a number of considerations, chief among them is cost.
This shouldn't come as a surprise. For years, cost of access has been a paramount concern. We can trace the trend all the way back to 1975, when, in founding The Vanguard Group, Jack Bogle built an investing empire on the back of low-cost investing. Even our research here at Morningstar has reinforced the idea that costs make a difference. We've shown that over the long term cost is an excellent predictor of relative performance; that funds with lower fees tend to outperform peer offerings.
Within ETF land, the traditional view of cost can be summarized with two words: "expense ratio." Investors often look to this metric as the all-in measure of an ETF's cost. Generally speaking, the expense ratio is a good yardstick. There are, however, a number of intangibles that, while frequently overlooked, do present the investor with very real costs.
I'd like to frame the question a bit differently here. I posit that when considering ETF costs, one should not merely ask what they charge. Instead, ask yourself what you initially expected to receive and whether or not it was what the product has provided historically.
Estimated Holding Costs
Most ETFs are index vehicles, and ideally, these funds should track their index, less the expense ratio. Under the performance tab, there is a table called "Total Cost & Risk." Our proprietary Morningstar data point that measures the gap in return between the ETF and the index is called "Estimated Holding Costs." In addition to the expense ratio, the estimated holding cost captures the realized cost of replicating an index. Indexes with high turnover or relatively illiquid constituents can be more costly to replicate. For funds that track these types of indexes, we would expect the estimated holding cost to be higher than the expense ratio.
Take for instance two funds tracking very similar indexes, the Dow Jones U.S.
Total Stock Market and the Dow Jones U.S. Index. They are tracked by SPDR Dow
Jones Total Market TMW and
We can attribute this additional lag to the fact that the SPDR fund is tracking a total market index which includes all U.S. securities available to investors, 3,718 securities in total. The iShares fund tracks an index that includes only the top 95% of the available market cap, amounting to a total of only 1,340 securities. In other words, we think the reason for the SPDR fund's greater lag to the index is due to the fact that small-cap stocks are harder to track, given their lower liquidity.
Generally speaking, the gap in return between the ETF and the index can be thought of as an additional cost. Note, however, that these figures will fluctuate from year to year and sometimes can even be positive. Significant and persistent deviations from expected levels of excess return should raise eyebrows. A good way to gauge the potential for deviation from the index is the data point "Tracking Volatility" (which can be found next to the estimated holding cost figure), or rather the volatility of the excess return figure over time. Again, given TMW's greater exposure to small caps, we would expect this fund to have a higher Tracking Volatility figure relative to the iShares fund. As such, investors looking for the best index-tracking ETF would be better off in the iShares fund. Those who are more bullish on small caps and want that exposure can pick the SPDR fund, the trade-off being that this ETF won't track as well as the iShares product.