ETFs, How Much do they Really Cost Me?

The
cost
of
an
ETF
can
be
roughly
divided
into
two
parts:

holding
costs and

transaction
costs.
The
relative
importance
of
the
two
components
will
vary
depending
on
the
investor’s
time
horizon
and
the
amount
of
money
to
be
invested.
Ownership
costs
include
fees
and
a
variety
of
other
factors
that
affect
the
relative
performance
of
the
replicated
benchmark.
Transaction
costs
include
commissions
and
bid/ask
spreads.

In
general,
holding
costswill
be
the
most
important
component
of
the
total
cost
for
long-term
investors,
as
they
are
by
definition
incurred
throughout
the
holding
period.
Transaction
costs,
on
the
other
hand,
will
be
more
important
for
investors
with
shorter
time
horizons,
particularly
in
cases
where
they
are
investing
large
sums
of
money.

Ben
Johnson,
head
of
ETF
research
at
Morningstar,
compiled
a
list
with
the
aim
of
identifying
the
main
components
of
the
total
cost
of
a
listed
replicant.

Holding
Costs

Commissions
are
generally
the
most
important
component
of
ownership
costs.
They
are
also
the
most
stable
and
readily
available
part
for
investors.
But
there
are
also
implicit
costs
to
consider,
arising
from
a
variety
of
factors.
These
are
listed
below.

Sampling

Some
ETFs,
especially
those
that
replicate
indices
containing
small
and
less
liquid
securities,
opt
for
sample
replication.
In
practice,
the
fund
buys
a
set
of
securities
chosen
to
create
a
portfolio
that
is
sufficiently
similar
to
the
benchmark
–
but
with
a
smaller
number
of
components
(usually
the
most
liquid)
in
order
to
optimise
liquidity
and
transaction
costs.
Although
sample
replication
has
some
obvious
advantages,
it
creates
a
potential
source
of

tracking
difference
as
the
fund
deviates
from
the
performance
of
its
benchmark.

Index
Portfolio
Turnover

Index
turnover
costs
reflect
another
potential
source
of

tracking
differences.
Bankruptcies,
mergers
and
acquisitions
are
some
of
the
most
common
causes
of
changes
in
a
standard
market
capitalisation-weighted
index
portfolio.
The
costs
associated
with
realigning
the
ETF
to
reflect
these
changes
could
cause
the
performance
between
fund
and
index
to
deviate.

Treatment
of
Dividends

The
timing
and
tax
treatment
of
dividends
are
another
potential
source
of
deviation
between
the
return
of
the
ETF
and
the
replicated
benchmark.
In
most
cases,
by
not
reinvesting
the
earnings
from
securities
in
the
fund
itself,
dividend-paying
ETFs
keep
these
earnings
in
the
form
of
cash
until
the
scheduled
ex-dividend
date.
This
practice
(called

cash
drag
or

dividend
drag)
can
potentially
create
a
negative
difference
between
the
replicant’s
performance
and
that
of
the
index
during
bullish
market
phases,
since
dividends
are
not
reinvested
in
the
fund.
However,
the
reverse
is
also
true.
That
said,
in
many
cases,
ETF
issuers
can
utilise
this
liquidity
by
investing
in
futures
contracts
to
maintain
exposure
to
the
market
and
thus
ensure
a
tight
replication.
Not
all
funds,
however,
can
employ
this
technique.

Also
not
to
be
underestimated
is
the
different
tax
treatment
of
coupon-distributing
ETFs.
The
distribution
of
the
dividend
in
fact
entails
a
double
taxation
of
the
investment,
one
on
the
appreciation
of
the
instrument
and
another
on
the
distribution
of
the
dividend
–
without
the
possibility
of
offsetting
the
two.
All
this
backfires
on
the
investor
in
a
situation
where
the
ETF
is
at
a
capital
loss
but
still
pays
out
coupons.
For
example,
in
the
case
of
selling
a
fund
at
a
loss,
the
capital
loss
cannot
be
offset
against
the
gains
received
in
the
form
of
dividends.

Securities
Lending

Securities
lending,
on
the
other
hand,
can
be
a
source
of
income
for
ETFs,
which
in
this
case
can
compensate
to
varying
degrees
for
the
costs
they
face.
The
degree
to
which
this
activity
affects
them
depends
on
a
variety
of
factors.
For
instance,

small-cap
funds
generally
generate
more
revenue
from
securities
lending
as
there
is
more
demand
from
short
sellers
to
borrow
small-cap
securities.

Tracking
Difference
VS
Tracking
Error

All
of
the
above
items
combine
to
form
the
difference
between
the
performance
of
the
ETF
and
the
performance
of
the
replicated
index.
The
most
intuitive
is
the

tracking
difference,
i.e.,
the
mere
difference
between
the
two
items.
Another
measure
often
used
to
analyse
the
behaviour
of
an
ETF
is
the

tracking
error,
which
measures
the
standard
deviation
of
the
difference
between
the
fund
and
index
performances
over
time.

Transaction
Costs
(Trading
Costs)

While
the
costs
of
ownership
are
more
or
less
fixed
and
linked
to
owning
shares
in
an
ETF,
transaction
costs
are
only
incurred
when
making
a
purchase
or
sale
transaction.
One
of
the
most
explicit
of
these
costs
is
the
commissions
to
be
paid
to
brokers
for
making
trades.
By
now,
in
truth,
there
are
quite
a
few
trading
platforms
that
allow
transactions
to
be
carried
out
at
very
low,
or
even
no
cost.

Then
there
is
the
bid/ask
spread,
also
known
as
the
bid/ask
price,
i.e.,
the
difference
between
the
best
buying
price
and
the
best
selling
price
of
a
security
(or
a
share
in
a
fund)
offered
by
market
makers
on
the
market,
who
then
match
supply
and
demand.
This
difference
represents
their
remuneration.

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