It's easy for investors to get wrapped up in the conversation regarding fees on exchange traded funds. For investors planning to hold an ETF for a year, three years, five years or longer, fees matter. Investors' increasingly fee-savvy ways are prompting fund issuers to bring new, inexpensive products to market as well as to continually pare expenses on established ETFs.
Investors win under those scenarios, but low fees are just one part of an ETF's total return potential. Obviously, the primary driver of a fund's performance is its underlying holdings.
“While CFRA agrees that an expense ratio matters — and we include it as one of the 10 inputs to form a more forward-looking ranking — what’s inside an ETF is the bigger driver of performance,” CFRA Research Director of ETF & Mutual Fund Research Todd Rosenbluth said in a note out Monday. “As more asset managers compete for ETF flows, the narrow differential in fees matters less.”
Cheaper Isn't Always Better
Data confirm that investors are drawn to low-fee ETFs. In the first 10 months of this year, 70 percent of ETF inflows went to funds with expense ratios of 0.2 percent per year or less, said Rosenbluth, citing Bloomberg data. Low fees are not always the reason why one ETF outperforms a rival fund.
Just look at the SPDR S&P Homebuilders ETF (NYSE: XHB) and the iShares US Home Construction ETF (NYSE: ITB). Sure, ITB's lower expense ratio helps, but it is not the primary reason why that fund is outpacing the rival XHB by a better than 2-to-1 margin this year.
“That performance difference, as CFRA has long maintained, comes down to what’s inside each of the ETFs. ITB holds 68 percent of assets in homebuilders,” said Rosenbluth.
Conversely, XHB is more levered to the retail side of the residential real estate trade, exposing the ETF to some of the negative trends faced by brick-and-mortar retailers this year.
An Emerging Markets Comparison
The Schwab Emerging Markets Equity ETF (NYSE: SCHE) is an investor favorite because its annual expense ratio of 0.13 percent makes it one of the cheapest emerging markets ETFs, but by emphasizing low costs, investors may be missing out. For example, the BLDRS Emerging Markets 50 ADR Index (NASDAQ: ADRE), which charges 0.3 percent annually, has outpaced SCHE by 25 percent this year.
“The sizable gap in performance records for the examples in this article is notable and serves as a reminder that proper due diligence means going beyond the expense ratio,” said Rosenbluth.
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