Understanding the costs of ETF selection

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When you shop for a car, you probably have a budget in mind. You likely also consider more than the sticker price, including implicit costs like reliability, fuel economy and how much it will cost to insure and repair. And you may consider opportunity costs, because buying one car means foregoing other options. Will the car meet your needs? How does it drive in inclement weather? Will it be able to handle rough back-country roads, or is it more of a city car? And can you count on this car to deliver the performance you expect over the long haul?

You face a similar challenge in evaluating exchange-traded fund (ETF) costs. As with cars, you’re faced with obvious, explicit costs such as the expense ratio. But that’s just the tip of the iceberg. Implicit and opportunity costs can also have a material impact on an ETF’s ability to help you achieve your desired investment outcomes.

Understanding the full range of costs associated with owning a particular ETF may help you make better-informed decisions about which one will suit your needs.

Explicit costs

Simply put, explicit costs are those you can easily see. They’re positioned front and enter on most fund materials and prospectuses and are mentioned widely in the financial press. Explicit costs include fund expenses as well as transaction costs.

Implicit costs

As the name suggests, implicit costs can be somewhat hidden in nature. They include costs such as capital gains and portfolio turnover, both of which require more thorough research and can be more difficult to measure than the explicit costs. Still, these costs can have a material impact on an ETF’s performance over time.

Opportunity costs

As with a car, choosing one ETF often means not choosing another, and this opportunity cost lies at the heart of the total cost of ownership.

Different ETFs may take markedly different approaches to providing exposure to a given asset class or category, which in turn can have a substantial impact on the performance it can deliver over time.

These differences can overshadow low management fees and impose unintended consequences on investors. Taking these and other opportunity costs into account can make a real difference in an investor’s ability to achieve their financial objectives.

For example, it’s important to understand how each ETF seeks to achieve its investment objective. Consider a few examples.

Sector concentrations

In the large-cap value category, for example, investors may discover that many ETFs in this category are concentrated in a few sectors, such as utilities and financials. If these sectors experience a steep decline, the ETFs holding them will suffer similarly in terms of performance. In addition, a large-cap growth ETF that adheres to a cap-weighted index could be concentrated in the technology or consumer discretionary sector, which could also be vulnerable to substantial declines. In contrast, ETFs that avoid such sector concentrations may deliver stronger, more consistent returns over time.

Geographic concentrations

Does the ETF in question feature any geographic concentrations, and do these unintended exposures add idiosyncratic risk to an overall portfolio? Keep in mind that concentrations in different countries or parts of the world can lead to unexpected variations in performance.

Approaches to portfolio exposure

If the ETF is investing in international securities, how does it gain exposure to those markets? American depository receipts (ADRs), global depository receipts (GDRs), futures or local stocks? How does it handle currency exposure? How does the portfolio manager balance high turnover, capital gains and index tracking?

In answering these questions, you’ll have a better understanding of potential opportunity costs that can impact investment performance significantly more than an ETF’s expense ratio. We believe that a well-designed product is critical to ensuring appropriate portfolio exposures while both managing risks and enhancing overall performance.

Always remember to look under the hood

Through this blog, I have presented a short overview of the costs associated with ETF ownership. For a deeper dive, read our latest publication, The Total Cost of ETF Ownership: Always Remember to Look Under the Hood (requires log-in). It presents a more in-depth analysis of explicit, implicit and opportunity costs, and it challenges some commonly held “rules of the road” in ETF selection.

Exchange-traded funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.

This information is for educational purposes only and is not intended as a personalized recommendation or fiduciary advice. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

For more information on the terms listed above, please see our glossary.