We’ve all seen it in the past few weeks—ETF issuers are in a race to zero when it comes to expense ratios. Too bad everyone has their eyes on the wrong set of costs.
Vanguard, Schwab and iShares have been at the forefront of the new ETF price war.
From launching new products such as the iShares Core MSCI Emerging Markets ETF (IEMG) to slashing fees on funds like the Schwab U.S. Broad Market ETF (SCHB) to cutting off ties to index names like MSCI, ETF firms have done everything in their power to gain ground in the price war.
The thing is, as ETF issuers focus on cutting costs down to zero, there’s been little focus on what I would argue is the most significant cost in the ETF space—trading expenses.
The Most Obvious Cost:Bid/Ask Spreads
Investors experience trading costs in a variety of ways. The most obvious is bid/ask spreads:the difference between the ask price—the price at which you can buy the ETF; and the bid—the price at which you can sell the ETF.
To get that in percentage terms, you simply divide that difference by the midpoint between the bid and the ask price.
Recently, there’s been a lot more discussion on how bid/ask spreads can affect trade executions for ETF investors. Often, issuers like to point out that they have the cheapest funds when spreads are taken into account.
As a retail investor wishing to buy the funds in the secondary market and hold them for a year, you’re looking at a total cost of 0.41 percent for GLD, and 0.31 percent for IAU.
The above example doesn’t tell the whole story for institutional investors, which my colleague Paul Baiocchi mentioned in another blog . Still, the truth is that I can never really agree with the spread and expense ratio calculation I’ve seen quoted by some.
Issues Incorporating Bid/Ask Spread Costs
For one, this sort of math always assumes that investors capture the spread when trading an ETF—meaning you’ll actually realize these “in and out” costs of a trade. But that’s not really the case.
Market makers can often walk an order up; that is, increase their asking price or, conversely, decrease their buying price. That basically moves the market if they begin to notice there might be size behind the order. As a market maker, you’d be stupid not to, as long as competition wasn’t too close behind you in making markets. Sorry folks, bills have to be paid.
Secondly, the denominator in the math is simply wrong. The expense ratio is a fixed cost based on the net asset value of the fund (NAV), while the spread is a varying cost based on the midpoint between the bid and the ask price.
Simply put, the denominators in both costs are not the same.
There’s an inherent assumption that an ETF’s midpoint is identical to its real-time indicative net asset value. But that’s seldom the case, especially with ETFs that aren’t liquid and tend to trade at a significant premium or discount.
In the end, the total cost calculation isn’t sound academically, nor is it the best reflection of reality.
Despite the fact that the inclusion of the bid/ask spread may understate transaction costs, it’s a great starting point. Many ETF issuers need to stop caring so much about expense ratios, and instead focus on the trading of their funds.
Larger issuers such as iShares dedicate whole departments—capital markets desks—to making sure spreads are reasonable within their products.
Smaller issuers that lack the manpower are often stuck hoping for the best. That’s what we saw in the case of the now-defunct FocusShares ETFs, which had some of the cheapest funds in their respective spaces, but also suffered from milewide spreads.
Attempts To Bring Spreads In
To be fair, ETF issuers as well as exchanges have made some progress in trying to solve the problem.
In the case of the BATS exchange, multiple market makers are allowed to seed a single fund as a way to dilute risks and increase competition and liquidity in a single fund. Market makers can then compete for a $250 reward each day for promoting liquidity and keeping tight spreads.
In an effort to compete against the BATS model, both NYSE and Nasdaq have begun to lobby regulators to allow for ETF issuers to pay market makers directly. In this model, issuers could pay a fixed fee of anywhere from $50,000 to $100,000 per ETF per year to a market maker.
It’s a nice effort, but frankly, I doubt it’ll really solve the issue.
Market makers would love the extra cash, but the issue with ETFs that suffer from low liquidity isn’t a matter of a receiving a check at the end of the year, it’s a matter of managing risks.
If a market maker sells a few shares in an illiquid ETF and ends up having to create an entire creation unit worth of the ETF, they also have to short its underlying securities, or use another proxy hedge in order to manage their net exposure.
Then there’s also the cost of financing both positions that market makers have to take into account. If that particular ETF doesn’t trade, market makers tend to lose money over time. In cases like this, market makers have to try to make this money back whenever they’re able to trade the product.
The direct payment model may alleviate some of the risks market makers face, but it doesn’t do much to solve the problem.
Additional Trading Costs:Creation Fees
Creation fees are seldom discussed in the industry—most likely because investors never really see how they actually experience them.
Rest assured, you’re always paying for them. Market makers pass on these fees when calculating the fair value for an ETF, basing their quotes on the final calculation.
Whenever a market maker or an authorized participant creates or redeems new shares of an ETF—whether creating or redeeming 50,000 or 500,000 shares—they have to pay a creation/redemption fee.
This fee is usually a fixed notional amount that the custodian for the fund charges for the actual delivery of the underlying securities in exchange for shares of the ETF.
Most ETFs have forgivable creation fees—a few hundred dollars per transaction—something that amounts to a few pennies for a typical 50,000 creation unit size.
However, creation fees can vary depending on the number and the nature of the securities in the fund, and there are definitely cases where they can get downright outrageous.
*Based on four days of trading
One of the most alarming creation fees I’ve seen in a while is actually that of the new iShares Core MSCI Emerging Markets ETF (IEMG).
The new fund sports a 0.18 percent expense ratio; however, its creation fee of $43,700 amounts to a percentage cost of 0.91 percent—assuming one creates 100,000 shares.
This fee is in stark contrast to what funds like the iShares MSCI Emerging Markets ETF (EEM) or the Vanguard MSCI Emerging Markets ETF (VWO) charge, which are much lower creation fees on a notional and percentage basis.
To be fair, IEMG digs deeper into the emerging market space than EEM or VWO. That results in a portfolio with many more securities, and securities that are much more “exotic” than the larger names you’d see in EEM or VWO. As a result, custodial fees are much higher.
Fortunately, for those currently buying IEMG, the full cost of the ETF’s creation isn’t being passed down. iShares made a brilliant move and allowed for a consortium of market makers to seed the fund.
The end result was that the aforementioned creation fee of $43,700 was spread over a total creation unit value of $81.9 million. Adding those two figures, the total cost to the consortium of market makers was somewhere around $81,943,700.
This sum, reflecting 17 creation units of 100,000-share units, differs significantly from the cost you’d expect from a creation of just one 100,000-share unit, which would have a value of $4.8 million.
Hence, at most, investors can expect an embedded cost of 0.05 percent relative to the fund’s net asset value for any shares that were part of the original seed capital.
Keep in mind, when looking at creation costs, these are the worst-cast scenarios of embedded costs. The more units a market maker can create, the more easily those costs can be spread out.
In the case of IEMG, investors won’t need to worry until the fund trades out of its seed capital—which amounts to about 1.7 million shares. After that, things get a little more interesting.
For market makers to mitigate the amount of the creation costs for IEMG that they’d have to pass on to investors, they’d have to create multiple units of the fund in the next round of creations.
However, for that to happen, a market maker would have to be sure it would be able to sell the newly created shares in a reasonable amount of time. That’s why understanding the creation units per day traded in a fund is crucial.
In the case of VWO or EEM, they both trade more than 80 creation units per day. There’s absolutely no concern there.
Although IEMG has a very short history behind it, it will need to do much better than the 0.54 creation units per day that it currently trades.
In essence, for investors not to realize the massive creation costs in IEMG, it will have to be precisely what some have suggested it isn’t supposed to be—a trading product.
For those out there still angry about having to switch out of EEM into IEMG, the grass isn’t that much greener on the other side. If you want to get in, I’d do it sooner rather than later to be on the safe side. Take a look at a quote screen for IEMG when you get a chance:You’ll notice a good amount of depth in the market—all those market makers are competing and ever so eager to get out of that seed capital.
I’d argue that ETF issuers have made their biggest impact in lowering overall costs by reducing and eliminating commissions.
I can go into my Schwab account and trade Schwab ETFs commission-free, or I can go into my Fidelity account and trade a select group of iShares ETFs commission-free.
Quite honestly, I can’t remember the last time I paid a commission to trade a cheap, broad market ETF. For that, I’m very thankful.
However, the time has come for a solution to the embedded trading costs that face ETF investors.
The amount of time and media attention given to expense ratios is comical at this point. Do we really have to do a dance because an expense ratio got shaved by 1 basis point? That’s daily tracking error against the index. My feet aren’t moving.
In light of the “flash crash,” price swings, erroneous trades and milewide spreads, it’s time ETF issuers begin to control the very aspect that made ETFs so alluring—liquidity.
Say what you will about mutual funds and high fees. At the end of the day, if I write a $10,000 check to Vanguard to get into a mutual fund, I know exactly what I’m getting—end-of-day NAV minus the annual expense ratio, assuming I got into a no-load fund.
Isn’t it time that we see a little bit of innovation on the trading side of ETFs that brings us closer to this?
At the time this article was written, the author held positions in EEM. Contact Ugo at firstname.lastname@example.org.
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