Looking beyond expense ratios

The first Australian exchange traded fund (ETF) was launched almost 20 years ago in 2001 and tracked the S&P/ASX 200. That ETF came with a management expense ratio (MER) of 0.286% and was predominantly popular with institutional investors due to its liquidity and cost transparency. 

Fast forward two decades and the industry has come on leaps and bounds. There are now over 200 ETFs listed on the Australian Securities Exchange (ASX) and market capitalisation for the industry, according to the ASX, is close to $70 billion as at 31 August, 2020.

Additionally, the proliferation of ETFs ranging from the broad market index ETFs that track the ASX 200/300 to the exotic, niche ETFs that focus on a specific sector, means that investors have a lot more choice. With choice comes competition and when coupled with lower direct costs, inevitably results in lower MERs. It is now possible to find not just one but several ETFs tracking the broad market indexes with 0.10% or less in MER. 

COSTS MATTER, UP TO A POINT

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At Vanguard, we are very fond of reminding investors that costs matter. This philosophy is grounded in unequivocal research which shows that, on average, investments with a lower relative MER typically outperform those with higher MERs in the long run, in terms of performance after MER. 

For the most part, investors who have simply chosen the lowest-cost index ETF have benefited from this choice for decades. However, present day expense ratios for core exposures such as Australian shares have compressed meaningfully and MER differences are now in the low single digits, thus becoming less of a differentiator.

While this broad-based downward shift in ETF MERs has undoubtedly resulted in better investment outcomes and savings for all ETF investors, it has also created a new dilemma. How does an investor select ETFs amid this new “everyone is a low fee provider” environment? 

In a field of similarly priced ETFs tracking the same index, an investor might look at their options and decide to go for the lowest cost one. Is it safe to assume they are a commodity and will deliver the same performance after MER? 

To answer this question using a cooking analogy, it’s a bit like a home cook believing that following the steps of a restaurant chef’s recipe alone is the secret to culinary success: slice and dice as the recipe dictates and a few hours later, you have a dish that rivals what you’d expect to be served at a restaurant.  

But as many of us have discovered through our kitchen exploits during the pandemic, even when cooking alongside online masterclasses run by Michelin-starred chefs – there is always more to it than just following a recipe with precision.

Managing an index ETF is not too dissimilar. Asset managers tracking similar indices can produce different results relative to their benchmarks despite facing the same opportunity set when it comes to managing your money. This is because resources, index expertise, investment sophistication, securities lending and other factors can provide an edge. Investors should not merely pick the lowest MER index ETF because, as with cooking, both the quality of your ingredients and the skills of the chef matter. 

So if fees are no longer the differentiator they once were, what other metrics of value can investors apply to sort through their ETF choices? Well, if you know what to look for in a low-cost index ETF provider, you can increase your chances of achieving superior after-fee performance vis-à-vis your target benchmark.

When searching for and selecting between core index ETF investment options today, investors should use a decision-making framework that takes into account a range of factors, including expenses, portfolio management capabilities, securities lending programs, spread costs and scale in more equal weights than in the past.

PAST PERFORMANCE DOES MATTER

As responsible financial institutions, we are legally obliged to provide risk warnings along the lines of “past performance is not a guarantee of future performance”, to make sure that investors are cognisant of the risks involved in any investment. That certainly holds true for equity index ETFs today, as some indexes and benchmarks can swing wildly in the short to medium term. That said, past performance of an index ETF relative to its benchmark can be a good indicator of the manager’s portfolio management quality, skill and expertise. 

Investors should look closely at the historical track records of each ETF and how it tracks against the benchmark and its performance after fees. There is little value in paying lower MER fees per annum if the lower MER funds underperform against the index by a significantly larger margin, essentially costing you in expected after MER returns.

Conversely, a fund with a higher fee that tracks closely against the index or even positively as compared to the index, would deliver you better after MER returns. 

Table 1 illustrates this point by comparing the fees and periodic performance of three hypothetical ETFs tracking a made-up benchmark termed X. Looking at the one year performance of ETFs A, B and C respectively, the thing that jumps out most is that ETF A broke even with the benchmark after fees, essentially earning the investor the entire expected benchmark return of 7.5%. 

On the other hand, ETF B cost the investor 0.06% in fees, despite the ETF tracking precisely with the benchmark. Finally, ETF C cost the investor a perceived 0.13% loss after fees because it underperformed the benchmark by 0.05%, before a further 0.08% fees. 

While the numbers are all hypothetical, it emphasises the need for investors to look carefully at both performance after fees and the cost of the ETF, before deciding on the best one to invest in.

Great index ETF managers can track the benchmark tightly and add incremental value to cover some, and on occasion all of your management fees. When the latter can be accomplished, it essentially means the investor is holding a zero-cost ETF. 

So how do good index managers do it and how can you tell them apart?

BIGGER CAN BE BETTER

Scale is a key differentiator, and one that is increasingly difficult for new entrants to achieve. 

Scale enables ETF managers to lower fixed trading costs like commissions or ticket charges, track or ‘replicate’ benchmarks with greater precision and strengthen relationships with trading partners, benefiting the end investor. 

SECURITIES LENDING 

Does your index ETF manager do it and do investors in the ETF get the full benefit? Securities lending is a widely used value-adding investment strategy involving the loan of portfolio securities to financial institutions that have a need to borrow such securities.  The ETF manager receives either cash or collateral to protect against the borrower failing to return the securities. While this basic framework exists across the globe, the approach or lending philosophy can vary significantly from manager to manager.

ETF investors should be appropriately compensated for assuming the risk associated with securities lending. However, this is yet another area where various index managers differ. The managers that deliver the most value are those who pass on the full securities lending revenues to investors, while some managers don’t do it at all or may keep a significant portion of the proceeds for their own benefit.  

SPREADS COUNT AS COSTS TOO

While we often discuss the broad issue of costs in terms of ETF management expenses, it should be noted that costs come in other forms too. 

Investors should assess the total cost of ownership in any investment. When it comes to ETFs, transaction costs – better known as bid/offer spreads – are also an important factor.

Spreads are paid each time an investor enters or exits a fund and covers the costs incurred in the transaction. There is no financial advantage in picking a low expense ratio

ETF if it comes with significant spread costs, as the spreads, like management fees, eat away at your overall investment returns. So cast your eye on liquidity and spreads of your ETFs and compare before clicking buy.

MANAGING AN ETF IS HARDER THAN IT LOOKS

In today’s capital markets, index ETF managers should increasingly be expected to produce returns that are, on average, approximately equal to their benchmark index minus their ETF’s expense ratio. 

This concept applies broadly across markets, while the costs – and the consequent performance drag – range from minimal in developed markets to modest in emerging markets. For sophisticated index ETF managers, opportunities exist to save and add value through more thoughtful daily management of the portfolio. Successfully taking advantage of these opportunities can in some cases effectively offset the MER and increase index ETF investor returns.  

In the US, there has been a lot of press recently around the launch of ‘zero-cost ETFs’. While we have not had any truly free, zero MER ETFs launched in Australia yet, if you look closely at an index ETF’s performance after MER, there are a number of Australian ETFs already worthy of that title.

Ultimately, not all index ETF managers are the same so it really pays to do your homework when choosing the right ETF for your portfolio. 

Duncan Burns is head of equity indexing at Vanguard Asia-Pacific.