If there is one hallmark of exchange traded funds most advisors agree on, it's the investment vehicle's low cost.
That cost is typically measured by an ETF's expense ratio, a number that has become the de facto ETF yardstick. In fact, many advisors and most investors don't look beyond the expense ratio when analyzing performance; they assume that exchange traded funds with the lowest expense ratios are the best, because it seems only logical that such ETFs would produce the greatest return for shareholders.
Surprisingly, however, that's not always the case. ETFs with the lowest expense ratios may not always be the least expensive choice overall or measure an ETF's total cost of ownership. That seeming contradiction results from several factors, but especially from the way markets function based on supply and demand. The interaction between supply and demand results in a level of liquidity for each ETF. The most-liquid ETFs — those with large buying and selling interest among market participants — are typically the least costly to trade, and therefore usually the least expensive overall when all costs, not just the expense ratio, are considered.
The presence of liquidity, of course, enables buyers and sellers to carry out their trading plans quickly and with little or no effect on price. Many individual investors assume liquidity is always present in securities markets, usually because they can buy or sell most actively traded stocks whenever they want at the last price or very close to it.
But even in active stocks, especially when markets are gripped by buying or selling fever, liquidity is not always present and it's not free. Its cost is reflected in the bid-ask spread, which reflects differences between buying interest and selling interest. The cost of liquidity, therefore, which determines the overall cost of trading, is an important consideration for advisors to keep in mind when selecting an ETF and ETF strategy.
Since ETFs have become the basis for many core portfolios, the total cost of ownership of a particular ETF takes on more significance given the periodic portfolio rebalancing that advisors must undertake. Suppose, for example, that an advisor creates a 60/40 core allocation portfolio for a client that is composed of a U.S. equity ETF, a global ex-U.S. equity ETF and a broad global bond ETF. While each of those ETFs is intended to be held for a long time, the periodic adjustments required to maintain the 60/40 allocation involve the buying and selling of each of those ETFs. Choosing more liquid ETFs that have a lower total cost ownership — even in cases where they may have a slightly higher expense ratio — can reduce the cost of rebalancing and maintaining the portfolio over the long run.
Just as liquidity in the secondary market is an important component of the total cost of ETF ownership, liquidity is also an important consideration in the behind-the-scenes market in which authorized participants — market makers, other financial industry professionals and large institutional investors — create and redeem ETF shares, a process that allows ETFs to be less expensive, more transparent and more tax efficient than traditional mutual funds.
The process of creating and redeeming ETF shares requires considerable trading in securities that constitute a particular ETF. Because of this ongoing trading, an ETF's liquidity must include the liquidity of its underlying holdings and in cases where spreads are wide in those underlying securities —particularly in cases where ETFs consist of less actively traded stocks — the total cost of ownership rises as the professionals who create and redeem ETF shares trade the less liquid securities.
The cost of liquidity, therefore, whether in the secondary market for the ETF itself or in markets for the securities that comprise the ETF, is an important factor for advisors to consider when selecting an ETF and ETF strategy. The cost can add several basis points, or hundredths of a percentage point, to the total cost of ownership, even exceeding the expense ratio in some cases.
When looking at an ETF's total cost, advisors and their clients can quickly see that the lowest expense ratio doesn't necessarily translate into a particular ETF having the lowest cost of total ownership. In short, an ETF that at first glance seems to be the least expensive many times is not, which is why advisors should always include liquidity analysis in their ETF due diligence.
Important Risk Discussion This material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. State Street Global Advisors and InvestmentNews are not affiliated. ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as “creation units.” Brokerage commissions and ETF expenses will reduce returns. State Street Global Advisors Funds Distributors LLC member FINRA SIPC. Exp date 8/31/2020 2698766.1.1.AM.RTL
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