From the December 2013 issue of Investment Advisor • Subscribe!

November 25, 2013

Pulling the Curtain Back on ETF Cost ­Efficiency

Smart ETF strategies can result in real savings for clients

ETFs were not intentionally created to lower investment costs for shareholders. This may be surprising news, but the thought process for creating an exchange-traded basket of securities actually came from an exchange.

Offering a pool of securities—and identifying how mutual funds developed into a multi-trillion dollar industry—changed the game for an exchange. Yes, it delivered an innovative investment vehicle with enhanced efficiency and accessibility, but another driving force existed: to create more revenue for an exchange itself.

The creators certainly recognized the potential benefits for shareholders of these products. Thankfully, one can look to the original exemptive relief filed with the SEC to understand the features and benefits designed for ETFs. None of those features mandated any type of pricing, with the exception that the first ETFs would be passive in their investment strategies.

As any advisor understands, if a manager does not add investment value, there should not be much of a fee charged, if any at all. In fact, the first ETF was structured as a unit investment trust (UIT), which does not charge a management fee. A UIT instead charges a trustee fee for the oversight that trustees provide in ensuring the ETF maintains its investment mandate and operates appropriately.

Among the greatest features intentionally designed for ETFs is the operational efficiency. The ingenuity of the ETF structure ensures that investors who buy and hold can do so cost effectively and are only charged the total expense ratio for holding an ETF over time, plus the commission. Investors who actively trade are charged the same and also pay for commissions and spreads for each transaction made with a market maker. The commission and spreads help offset a market maker’s cost of holding inventory. Therefore, the cost friction from active traders does not impact the long-term shareholders.

In fact, having investors who trade more actively helps narrow the spreads, and if buy-and-hold investors look to sell or purchase more shares, they can save additional money. Trading among active shareholders can also cause an abundance or shortage of inventory, requiring the market maker to go to the ETF provider directly to create or redeem shares.

For most ETFs, the process for creating and redeeming shares is done “in kind,” which involves less cost to fund shareholders by not having to buy or sell any underlying securities. The market maker pays the cost to move those shares directly in and out of an ETF. In doing so, the market maker is an authorized participant that pays a creation unit fee, which is listed in any ETF prospectus. None of these costs impacting an ETF are borne by passive shareholders, who instead benefit from narrower spreads and better tax efficiency.

Those are real cost savings not displayed in the expense table of an ETF. For example, let’s use actual long-term capital gain distributions from 2012 in a $7 billion index mutual fund—U.S. domestic equity large blend—that pays a $0.06 capital gain on $10.69 NAV, which equals a 56 basis point annual distribution. Since the distribution is a long-term gain, let’s assume a 15% tax rate that translates into a real investment loss of 8.4 basis points. Take into consideration that this index mutual fund has a seven basis point total expense ratio. If the fund’s strategy was offered in the more operationally efficient ETF structure, it has the potential to save at least 8.4 basis points if not more from the internal drag of the transactions. Such a scenario in effect would offer the mutual fund strategy in an ETF structure for free.

To be clear, it’s normal for a fund to have taxable distributions. However, an investment strategy delivered in an ETF vehicle could present significant positive impact on your clients’ long-term returns.

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