Exchange-traded funds are known to be transparent, tradable, tax efficient and low cost, says Morningstar Director of global ETF research Ben Johnson in a blog post, Calculating the Total Cost of ETF Ownership, so investor selection of ETFs solely based on fees may be misguided. In fact, he says, “it’s important to look beyond the headline fee and take a more holistic approach to assessing the cost of ETF ownership.”

Johnson goes on to detail the total costs of ETF ownership, which he says can be roughly split between holding costs, which include fees and other factors that affect an ETF’s tracking performance, and transaction costs, which include commissions, bid-ask spreads and market impact. These costs vary chiefly “on an investor’s time horizon and the amount of money he is looking to invest.”

He notes that holding costs are a bigger factor for long-term investors as they are incurred while holding the product, while transaction costs are more of a factor for short-term investors, “particularly in cases where they are looking to invest large sums of money.”

Cost #1: Sampling

“The manner in which funds seek to replicate their benchmarks can also be a substantial source of implicit holding costs,” Johnson says. For example, sampling, which is a technique to replicate returns of a benchmark index by using a basket of stocks to mirror the index, could create a tracking differential to the index.

He says one sampling example is iShares MSCI Emerging Markets ETF (EEM). Before 2010, the fund held only about half the stocks in the index. Due to this and a “relatively high expense ratio,” the fund trailed the actual index by nearly 10 percentage points. Compare this to Vanguard’s MSCI Emerging Markets Index, which used a full-replication approach and was off only two percentage points from the benchmark.

Cost #2: Index Turnover

Index turnover also cause tracking issues. Companies in an index can go bankrupt or merge or be acquired. “The costs involved in realigning the portfolio to reflect these changes may ultimately show up in funds’ benchmark-relative performance,” Johnson writes.

Cost #3: Dividends

Timing and tax treatment of dividend payments can cause tracking issues for ETFs, Johnson says. The lapse between the funds’ ex-dividend dates and dividend payment dates can affect tracking performance, depending on how the portfolio manager handles that cash. Some “equitize this cash by investing in futures to maintain market exposure and ensure tight tracking,” he says. But some funds can’t do this and it has hurt tracking performance.

There also can be issues dealing with dividend taxation, especially with international equity funds that might be located in multiple jurisdictions. Tax treatment embedded in an index’s calculation may differ from the “reality of the fund,” which could be good or bad for the fund’s performance, Johnson writes.

Cost #4: Securities Lending

Of course, this can be a source of revenue to offset holding cost, Johnson notes, but how much of it adds to the fund’s performance can depend on the lending activity. Small-cap funds usually earn more in securities lending than large-caps, for example.

Other Costs

How does an investor know how much these costs hurt the performance of an ETF versus its benchmark?  Johnson writes that the most obvious measurement is to track the difference. “ETFs and index funds would be expected to product returns that lag its benchmark by an amount equal to its expense ratio,” he says.

Tracking error, which measures the standard deviation of the difference between an ETF’s return and the benchmark’s return over time, is another factor.

Trading costs also are a factor. This is a commission, and according to Johnson, this is now usually less than $10 per trade. Some ETFs do trade on a commission-free basis.

Also consider within trading costs the bid-ask spread. This varies largely on market liquidity (more liquid market, tighter spreads) and market volatility (more volatility, wider spreads).

Finally, market impact — of how the market might move against you — is another cost.

“Transaction costs matter far more than holding costs in the total cost math for very short holding periods,” Johnson says. Holding costs matter more for long-term holders.

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