Expense Ratios Can Be Misleading
The big ETF stories of the past week have been about fees. BlackRock lowered the expense ratios on a number of key ETFs. Schwab, always reluctant to be outdone, countered with its own reductions. Elsewhere, analysts were multiplying expense ratios by assets under management to calculate the revenue impacts from the fee cuts, and how much total revenue the overall ETF industry was generating. However, for the individual investor, total return and the risk associated with that return remains the bottom line.
Much like bond yields, where the floor was historically thought to be 0%, expense ratios can theoretically dip into negative territory. How can this be? For starters, expense ratios do not tell the whole story. Many ETFs have other sources of income than what they disclose in their expense ratios. Securities lending to short-sellers can be quite lucrative if the ETF has securities that are in-demand. However, that comes with additional risks, including the obvious one that the ETF is holding stocks that short-sellers believe are destined for a fall. If the short-sellers are correct, then the borrowed shares will be returned to the ETF at a lower value.
Another way that ETFs, or their managers, can earn money is through the creation and redemption process. Inside the prospectus, you will see that ETFs charge a fee for this service. There are numerous examples of ETFs with a $500 creation fee for 25,000 shares. For high-turnover ETFs, with multiple creation and redemption baskets each day, this revenue can add up quickly. Some ETFs, like the iShares 20+ Year Treasury ETF (TLT), do not have creation or redemption fees for in-kind exchanges, but they charge from 2% to 3% for cash redemptions and creations.
Additionally, most ETFs incur costs that are not reflected in the expense ratio but are ultimately absorbed by the shareholder. When funds perform their quarterly or annual rebalancing, there are expenses tied to the brokerage commissions and bid/ask spreads on every underlying stock transaction. These are not in the expense ratio. For some commodity funds, these buried transactional costs can be quite large. The now defunct FactorShares ETFs were some of the most egregious examples, with 12-month break-even costs ranging from just under 10% to more than 33%.
Another cost borne by ETF shareholders that is not in the expense ratio is the income taxes paid by a fund. For 99% of all ETFs, this is not a problem because they are structured as pass-through vehicles and do not pay any taxes. However, the other 1% are organized as C-corporations, which makes them liable for the 35% federal corporate tax rate plus state taxes on all taxable income. This deferred tax liability can be a big impact on shareholder return in rising markets, and it might not show up in the expense ratio until later years.
Another deceiving factor about expense ratios is that the ETFs with the lowest expense ratios often have the highest potential risk. They tout their low turnover and passive approach, which means they are also subject to the full brunt of market declines. A small expense ratio will be of little comfort the next time the S&P drops 56%, the NASDAQ crashes 77%, or the Tokyo Nikkei drops into oblivion.
Expense ratios do not reflect all of the revenue received by a fund and do not capture all of the costs that shareholders ultimately pay. For these reasons, investors should prioritize shareholder total return, realized risk, and risk management while placing less emphasis on expense ratios. After all, isn’t that the bottom line?
The sector chart is mostly red today, as three more sectors slipped into negative trends and the declines steepened for those already there. Energy climbed the final step to the top of the rankings and was one of only two sector categories to post a momentum increase this week. Technology, while still strong, slipped a peg after nine weeks at the top. Financials, now that it is free of the REITs that would have dragged it down this week, was the other sector improving its upward trend. Financials also climbed a notch to third, and it is one of the three sectors still in positive trends. Industrials, Consumer Discretionary, and Materials lost their last slivers of positive momentum. Health Care, Telecom, and Consumer Staples steepened their slides. Utilities had a tough week but managed to climb off the bottom. Real Estate, long classified a sector in our rankings and now recognized as such by the Global Industry Classification Standard (“GICs”) and major index providers, dropped into last place. The newly minted sector has lost 5.6% already this month and is down 11.0% from its early August value.
The four smallest-capitalization categories still control the top of the rankings but their margin is definitely shrinking. Micro-Cap leads the pack, followed by Small-Cap Value, Small-Cap Blend, and Small-Cap Growth. The lower portion of the rankings have been in constant flux with the Mid-Caps and Large-Caps having been unable to agree on which capitalization strata is superior. This week, the Large-Caps moved up and grabbed the middle ground, with Mega-Cap in fifth and both Large-Cap Value and Large-Cap Blend close on its heels. The Mid-Cap categories all fell lower, with Mid-Cap Value dropping three spots, Mid-Cap Blend falling four, and Mid-Cap Growth giving up one. Mid-Cap Growth was actually the worst performer of the three, but it couldn’t fall any lower than last place. Both it and Mid-Cap Blend now have negative momentum readings.
Latin America boosted its momentum score by 17 points to take over the global leadership role from China. Latin America is no stranger to the top position, having ended an eight-week residency there just two months ago. China didn’t fall far though, landing in second place and holding up much better than other regions in a week of broad declines. The next three categories held their positions, with Emerging Markets, Pacific ex-Japan, and Japan rounding out the top five. There was some shuffling in the lower tier as EAFE slipped three spots lower allowing World Equity, the Eurozone, and the U.S. to move higher. Canada sits above the U.K. on the bottom, but their near-tie of a week ago has been broken with the U.K.’s steep fall into the red. Stocks in the U.K. are actually trending higher, but the 9% drop in the British pound the past five weeks produced a loss for U.K. ETFs that do not employ currency hedges.
The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.
“To a certain extent, the cost war we’re seeing isn’t dissimilar from a supermarket that tries to get you in the door with a sale on a staple, knowing you’ll also buy expensive mango chutney while you’re there.”
—Lee Kranefuss, one of the founders and creators of iShares and currently the co-founder of 55 Capital
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