ETF Cost Structure Results in Better Performance

ETF EDUCATION: ETFs are generally cheaper than traditional funds, which usually results in better performance

Lee Davidson 17.04.2012
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Exchange-traded products (ETPs, which are more commonly referred to as ETFs) offer investors several benefits over other managed investment products, including lower costs, greater transparency, and more trading flexibility. Morningstar's research has shown that low-cost funds outperform high-cost funds in every time period and category studied. Since ETPs tend to cost less on average than traditional funds, ETPs should warrant serious investor consideration. Moreover, compared to traditional funds, investors using ETPs have more control over their portfolio's level of diversification and asset allocation due to their tendency for transparency. Most ETP providers publish their portfolios freely and frequently on their websites implying that investors can manage their risk exposure with greater ease and confidence than ever before. Finally, ETPs provide fund investors with unmatched flexibility due to their ability to be traded intra-day on an exchange and sold short. Many ETP providers also allow futures and options on certain products.

Benefit of ETFs #1: Lower Costs
Low costs are the chief benefit of owning an ETP. When choosing to purchase any kind of managed product, investors should seriously consider the costs associated with that purchase. While performance cannot be predicted with accuracy, costs are clearly defined and will be levied (usually) regardless of performance. By implication, higher fees should result in lower realised returns. This relationship is not only intuitive, but it turns out to be true. In every period and every investment category, high-cost funds underperform low-cost funds based on historical data tabulated by Morningstar's Russ Kinnel. Academics have also broadly confirmed this relationship. In a widely referenced paper called "On Persistence in Mutual Fund Performance," Mark Carhart demonstrated that expense ratios and loads are strongly and negatively correlated to performance. Costs have been empirically shown to be the single greatest predictor of fund performance.

Expense ratio data substantiates the ETP industry's claim to lower costs. Blackrock, owner of iShares--the world’s largest ETP provider--estimates that the average expense ratio for equity ETFs is 0.41% compared to 0.92% for traditional equity index funds. Not surprisingly, actively managed equity funds have a higher average expense ratio equal to 1.86%. For fixed income ETFs, the average expense drops to 0.19% compared to 0.39% for index funds and 0.99% for active funds tracking fixed income securities. Therefore, across asset classes, ETFs charge less than a comparable fund on average. How are ETFs able to charge less?

ETPs are cheaper on average than competing traditional funds because ETPs tend to have:
1) low turnover
2) a lean administrative structure
3) are traded on an exchange

First, ETPs tend to track an index, which typically implies that the turnover will be substantially lower than a traditional active fund. Turnover is the practice of selling securities and buying replacement securities. Index-tracking funds don't turn over their portfolios too often because most indices are market capitalisation based, which lends itself to relatively static composition. On the other hand, active stock-picking funds typically trade their portfolio more frequently and incur more transaction costs. Since transaction costs tend to get passed on to the investor, higher transaction costs will result in higher fees. Therefore, ceteris paribus, lower turnover implies lower fees. The relationship between turnover and costs has been highlighted elsewhere by Morningstar's Chris Traulsen and in numerous studies by academics (e.g. Carhart 1997). However, turnover is not the only factor contributing to the lower cost of ETPs, since ETPs tend to be cheaper than even comparable index funds.

In addition to low turnover, ETPs also tend to have leaner administrative organisations, and consequently, lower overhead. Actively-managed funds typically employ analysts to pick apart company financial statements, charts, or make economic forecasts in order to inform their investment decisions. However, ETP providers simply need to pay relatively small licensing fees to replicate an index--eliminating the need for an army of highly-trained analysts. Therefore, the costs to run an ETP compared to an active fund are considerably less. When costs are lower, ETPs are able to charge lower fees, which benefits investors.

Finally, ETPs tend to be cheaper than unit trusts, OEICs and even index funds because they trade on exchanges. By virtue of being listed on a public exchange, a number of the plethora of middlemen that exist between the provider and the end investor in the traditional fund distribution channel are disintermediated. Streamlining distribution serves to further slash the cost of investing in an ETP versus a traditional fund for the end investor.

It is important to note that the lower costs inherent in ETPs are due entirely to their structure and the fact that they are exchange-listed. As such, barring any legislative changes or the entrance of new products, ETPs should continue to be one of the lowest-cost investment options available.

Benefit of ETFs #2: Transparency
Another advantage ETPs boast versus other investment products is greater transparency. Traditional funds and ETPs, as defined under UCITS, are only required to report their full portfolio holdings on an annual or semiannual basis. These lax disclosure requirements can have negative implications for investors’ asset allocations. Specifically this 'black box' structure could result in the unintentional over- or underweighting of certain securities, industries, sectors, styles, etc. than what was originally intended. An investor looking to diversify their holdings across different sectors, asset classes, and industries may actually end up with an extremely concentrated portfolio depending on the decisions of the fund managers they’ve selected. Due to a lack of transparency, the investor may never realise unwanted portfolio concentrations and unintentionally assume higher risk.

Despite being included under these loose disclosure requirements, ETPs largely sidestep this issue because of their tremendous tendency for transparency. The vast majority of ETP providers publish their holdings on their websites each and every trading day so that investors can see what exactly they are buying into and what they currently hold. It is worth noting that this is merely industry practice and not required under UCITS. In Europe, for example, synthetically-replicated ETPs do not disclose their portfolio holdings as frequently or freely as their physically-replicating brethren--though most do provide full disclosure of their collateral or substitute investment baskets on a daily basis. Portfolio transparency assists investors in evaluating how closely an ETP tracks its underlying reference index, and puts investors in the driver's seat when it comes to asset allocation.

Benefit of ETFs #3: Trading Flexibility
Another potential advantage that ETPs have over traditional funds is trading flexibility. ETPs can be traded throughout the day, so you can buy and sell them whenever the market is open. Similar to stocks and unlike traditional funds, ETPs can be sold short. While short selling does entail some additional requirements and risks (e.g. posting margin, margin calls, theoretically unlimited losses, etc.), the ability to sell short effectively doubles investors’ investment opportunity set. Finally, the increasing availability of options and futures on certain ETPs offers investors an increased ability to hedge risk, gain exposure to new markets, and decrease costs. In short, ETPs have been designed to offer unprecedented trading flexibility compared to other managed-products.

Lee Davidson is an ETF analyst with Morningstar.

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Lee Davidson

Lee Davidson  is Head of Manager and Quantitative Research at Morningstar.

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