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 costs associated with owning a particular ETF may help you make better-informed decisions about which one will suit your needs.
Simply put, explicit costs are those you can easily see. They’re positioned front-and-center on most fund materials and prospectuses and see wide mention in the financial press. Explicit costs include fund expense as well as transaction 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.
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 provide 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.