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September 18, 2014 at 12:04 PM
There are significant misconceptions that exist about the total expense ratio of ETFs, including among some people considered ETF experts. The total expense for shareholders often includes the following: management fees, operating expenses, 12b-1 fees (yes, there are ETFs that charge a 12b-1 fee), commissions and bid/ask spreads. Commissions and spreads are usually listed as transactional or one-time expenses. As an example, if an ETF is bought and held for 10 years, then only the commission and technically half the spread are paid once, with the other fees charged on a continuous basis during the holding period.
A variety of other fees apply to both mutual funds and ETFs, with some more visible than others. Underlying fund fees are a prime example. If a portfolio manager chooses to buy the SPDR S&P 500 ETF (SPY) over purchasing all 500 securities within the S&P 500, then that manager’s fund must list the underlying fund fees of SPY. On the other hand, a manager who buys individually all 500 securities of the index also incurs significant charges, but is not required to disclose those costs in the expense table—however, the costs are there and can impact the performance (or NAV calculation) of the fund. It’s an unfortunate inconsistency in the regulatory reporting requirements.
When looking at how the industry classifies and calculates total expenses associated with buying and selling ETFs, it’s critical to break down those expenses into two categories: negotiable and non-negotiable.
Non-negotiable expenses include the management fee, operating expenses and, if the ETF has one, a 12b-1 fee. Likely the only items that change over time are the management fee and the operating expenses. The management fee can change if the ETF provides for break points as it grows more assets under management. An ETF’s growth should also reduce operational expenses, as a component of those expenses are flat fees that gradually become a smaller percentage of total assets over time as a fund increases in size.
