Why the cheapest ETF isn't always your best option
The ETF fee war has convinced many investors that cheaper is always better. But when the difference amounts to just a dollar or two a year, there are far more important questions to ask before you invest.
The exchange-traded funds (ETF) fee war has been good for investors. Providers keep cutting fees as they compete for investor money, and that means more of your money stays invested rather than disappearing in costs.
I've long been a champion of investors keeping their fees as low as possible, but once fees get very low, the difference between one ETF and another can become tiny.
If two ETFs differ in fees by only one or two basis points, there are other things worth looking at before blindly choosing the cheaper one.
What does a tiny fee difference actually mean?
One basis point is 0.01%.
On a $10,000 investment:
- A fee of 0.14% costs $14 a year
- A fee of 0.15% costs $15 a year
- The difference is $1 a year
Start with what you are actually buying
Two ETFs can sound similar but give you quite different exposure. Take broad Australian share ETFs.
One might track the S&P/ASX 200 and hold around 200 of the largest listed companies. Another might track the S&P/ASX 300 and hold around 300.
International ETFs can very much more.
One could be heavily weighted towards US technology companies, while another is spread more broadly across countries and sectors. Currency exposure can also differ, with some ETFs hedged back to Australian dollars and others left exposed to movements in the currency.
The companies the ETF holds determine where your returns come from and what risks you're taking.
A tiny fee saving is usually much less important than ending up with the wrong exposure.
The management fee is not the whole cost
The annual management fee gets most of the attention because it is easy to compare, but it isn't the only cost.
ETFs also have a bid-ask spread when you buy or sell. For large, heavily traded ETFs, this can be small, while more specialised ETFs can have wider spreads.
Trading costs are another part of the picture, particularly when annual fees are already very small.
Check the bid-ask spread
If an ETF is quoted at $50.00 to buy and $49.95 to sell, the five-cent gap is known as the bid-ask spread.
In this example, the spread is about 0.1%, or roughly $10 on a $10,000 trade.
The larger the spread, the higher the trading cost.
Why the index return isn't always your return
An index ETF has a fairly simple job: follow a benchmark such as the S&P/ASX 200 or S&P 500.
But the return from the ETF won't always exactly match the return from the index, this is known as the tracking difference.
How the fund buys and sells investments, handles index changes, manages cash, its tax treatment and the fees it charges can all affect how closely it follows its benchmark.
So, if you're comparing two ETFs tracking the same index, a lower management fee doesn't tell you everything. It's also worth looking at how closely each has actually tracked the index over time.
Look at concentration
An ETF might own hundreds of companies but still have a large chunk of the portfolio sitting in its top 10 holdings.
Another may spread its money much more evenly. That matters when comparing ETFs with similar fees.
One might cost a fraction less but have much more of your money tied to its largest companies, sectors or themes.
Concentration isn't necessarily a problem if that is the exposure you want, but it does increase risk.
If a large share of the ETF is invested in just a few companies or sectors and they fall, that can drag down the ETF's overall return
Look at the largest holdings and their weights, not just the total number of companies.
And, look at how your ETFs work together
When you own several ETFs, look at how they fit together too.
Two ETFs can overlap more than you think, holding many of the same companies or giving you similar exposure and leaving your overall portfolio more concentrated than it looks.
This is something we consider at InvestSMART when building our portfolios. We combine ETFs across different markets and asset classes, with the aim of avoiding unnecessary overlap and building a well-diversified portfolio.
Of course, fees still matter
None of this means investors should stop caring about fees.
Over long periods, high fees can eat into returns. But once costs are already very low, the cheapest ETF isn't automatically the most suitable one.
Six things to check before adding an ETF to your portfolio just because it's cheap
- What does it own?
Look at the index, holdings, countries and sectors. - What does it cost?
Compare management fees, but don't stop there. - How closely does it track its index?
Compare the ETF's return with its benchmark over time. - How concentrated is it?
Look at the weight of its largest holdings. - How does it fit with what you already own?
Check whether it overlaps with your other ETFs. - Does it suit what you are trying to achieve?
Consider your goals, timeframe and comfort with risk.
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