March 5, 2013

ETF Costs: What to Watch For

S&P Capital IQ’s Todd Rosenbluth provides helpful, and surprising, advice for ETF success

An industry rule of thumb is that ETFs with less than $50 million in assets don’t long survive. But those between $50 million and $100 million? They may be just what your clients are looking for.

Todd Rosenbluth, S&P Capital IQ’s director of ETF research, points to a number of ETFs with asset bases below $100 million that are ranked favorably by S&P Capital IQ. However, when looking at these ETFs, he cautions that it is important to understand the cost factor implications, as some of the smaller ETFs incur high costs.

“There is a repeatedly shown wireless phone commercial about one company's 4G data services that claims, 'It's not complicated. Bigger is better,'" Rosenbluth begins in newsletter commentary. “For exchange-traded funds (ETFs), this is not always the case.”

He explains that while some investors may look for the ETF with the most assets within a given style, others that have long focused on mutual funds may be drawn in by an ETF's strong performance record.

“[We] believe both approaches miss out on a number of factors, including that ETFs with limited asset bases tend to have higher expense ratios, less liquidity due to limited trading activity, and trade above or below their net asset value, thus costing more.”

Less frequent trading, he adds, can lead to wide bid/ask spreads, which is the gap between the price buyers are willing to pay for shares of an ETF and the price sellers are asking. The wider the spread, the bigger the bite taken out of investors' returns every time they buy or sell. A lack of liquidity also may cause the ETF to trade at a premium or discount to the net asset value of the fund's underlying holdings.

“That means an investor buying the fund may overpay for that portfolio or the seller may get less than assets are worth,” he argues. “Ideally, you can find an ETF with a style you favor that has a tight bid/ask spread and trades in line with its NAV because you need to not only get in but also get  at a later date. S&P Capital IQ uses these two cost factors, along with analysis of an ETF's expense ratio, to support our ranking process of 750 equity ETFs. According to BlackRock, over $47 billion was added to equity exchange traded products in the first two months of 2013.”

He points to the small-cap ETF space as on such example these high costs, and specifically PowerShares.

While PowerShares has gathered assets for a number of its fundamentally driven ETFs, PowerShares Fundamental Pure Small Core Portfolio (PXSC) is not one of them. PXSC has just $15 million in assets, and just over 800 shares trade hands each day. As a result, this ETF has a relatively wide bid/ask spread and a high 1.22% gross expense ratio, though PowerShares has agreed to waive 0.83% of these costs until at least August 2013, in an attempt, we think, to make PXSC more competitive. So while PXSC's market price total return of 9.7% year to date through March 4 is encouraging, the ETF has unfavorable cost factors to S&P Capital IQ.

A larger and better alternative, according to Rosenbluth, is the iShares Russell 2000 Index (IWM). IWM rose 8.1% year to date, narrowly lagging PXSC. While this ETF is a more traditional index ETF that is not tied to a benchmark that uses dividends or cash flow analysis, it is a lower-cost, more actively traded option. IWM has $19 billion in assets, and more than 30 million shares change hands daily.

“The bid/ask spread is tight and the gross expense ratio is just 0.23%,” Rosenbluth writes.

Lastly, he points to RevenueShares Navellier Overall A-100 Fund (RWV) as an example of “where bigger is not better." RWV's NAV is up 13% year to date through March 4, putting it among the 50 top-performing equity ETFs this year. The ETF is tied to an index that aims to identify the 100 highest quality stocks in the U.S. using factors such as earnings growth, free cash flow and return on equity.

However, he concludes, there is “only $7 million in assets in this ETF and the average daily volume is just 500 shares. Based on this, it is should be no surprise that the bid/ask spread is relatively wide and the gross expense ratio of 1.42% (net of 0.60% after fee waiving) is above average.”

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Read S&P’s Stovall: Pleasing Market Tally for 2012, Warning for 2013 by Gil Weinreich on AdvisorOne.

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