Morningstar highlights intangible costs of ETF ownership

Jun 21st, 2012 | By | Category: ETF and Index News

Morningstar, a provider of fund research and analytics, has published details of a study which delves into the data points that measure the true cost of ETF ownership. The key finding: keep an eye on Total Cost of Ownership (TCO).

Morningstar highlights intangible costs of ETF ownership

Keep an eye on TCO: Investment performance is directly related to Total Cost of Ownership.

The study, ETF Total Cost Analysis in Action, co-authored by analysts Paul Justice and Michael Rawson, highlights the easily-overlooked intangible costs of ETF ownership.

The study finds that ETFs with 4- or 5-star ratings are correlated with low costs and outperformance of their respective indices. These ETFs also tend to have lower tracking volatility and market impact cost than lower-rated funds.

Interestingly, ETFs incepted before 2005 have lower estimated holding costs, lower tracking volatility, and lower market impact than newer ETFs. On average, ETFs issued since 2008 have a tracking volatility nearly five times greater than those incepted before 2005.

ETFs in categories with higher expense ratios, such as alternatives, tend to have higher costs in terms of both tracking volatility and market impact. For example, the 37 ETFs in Morningstar’s Trading-Leveraged Equity category had an average expense ratio of 0.98 percent while the average holding cost for this group was 1.49 percent. Meanwhile, ETFs in the Large Blend category had an average expense ratio of 0.19 percent and an average holding cost of 0.17 percent.

In summary, Morningstar found that ETFs carry a number of advantages over traditional funds, such as lower average expense ratios. However, while the advantages are clear, the disadvantages can be difficult to quantify. These disadvantages include trading costs and tracking risks. While clearly ETFs cost less on average, poor trade execution or poor ETF selection can actually negate the expense ratio advantage.

Consequently, investors are advised to keep a close eye on the total costs of ETF ownership. Factors to consider (detailed below) include tracking volatility, estimated holdings costs, and market impact.

Tracking Volatility: a measure of how closely an ETF follows its benchmark index on a day-to-day basis. Typically caused by sampling error or incomplete replication of the benchmark portfolio, tracking volatility can cause an ETF’s performance to deviate dramatically from its index over time.

Estimated Holding Cost: a measure of cost that takes into account both explicit and indirect expenses and payments, like income to the ETF from lending shares to options traders. This measures long-term deviations from the index excluding intraday volatility.

Market Impact Cost: a measure of an ETF’s liquidity, by calculating the basis point change in an ETF’s price caused by a $100,000 trade. ETFs with lower liquidity can cost more to buy as large purchases drive up their price.

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