In the past few years, the number of high quality Exchanged Traded Funds (ETFs) available to the average investor has increased dramatically. As always, the additional choices come with a tradeoff: there are better options than ever before, but finding the best option is more difficult than ever (and most people are going about it the wrong way, and possibly leaving money on the table in the process).
A Proliferation of Choices
If you want to invest in the entire US stock market, for instance, a few years ago you would have had one obvious choice. You can now select either the Vanguard Total Stock Market Index Fund (VTI), the iShares Core Total US Stock Market Fund (ITOT), or the Schwab US Broad Market ETF (SCHB), all of which have expense ratios under .1%.
Unlike mutual funds that attempt to beat their benchmarks through actively selecting individual stocks, there are no obvious "skill differences" per se between ETFs that are managed against similar benchmarks. Instead, investors should be concerned with minimizing the costs that they have to pay, both to their brokerage provider, and to the company that manages the ETF.
Since these costs can be accurately estimated or known ahead of time, that means that selecting the right ETF for your needs should be an objective process that has a right answer as well as several wrong answers.
Evaluating ETF Costs Through the Dollar Cost of Annual Ownership Framework
The largest mistake investors make is to focus on one kind of cost that is associated with owning an ETF, rather than taking a holistic view of all of the costs. There are three kinds of fees that you need to consider:
- Trade Commissions. When you make a trade to purchase a new fund or re-balance your portfolio, your brokerage may charge you a commission. This is usually a flat fee. Many brokerages will partner with an ETF provider to enable you to trade select funds free of any commissions.
- Liquidity Costs. Whenever you enter or exit a position or part of a position, you will also implicitly pay a cost that you do not actually see. This is because at any one time, there will be a small difference between the price that you can buy a fund at, and the price that you can sell it at. This is known as a "bid-ask spread." Funds that are traded more heavily (more "liquid") will have lower implicit costs then those that are traded less frequently.
- Management Fees. ETFs charge an explicit annual expense ratio that is quoted as a percentage of overall assets. A fund that has a .08% fee will automatically deduct 8 cents per year for every $100 you have invested in the fund.
A complicating factor is that some of these are fixed costs (e.g. $8 per trade), and others are percentage costs (e.g. .08% of assets). It is not easy to make a direct comparison between the two. We need a way to compare different options on the same scale.
The best way to do this is to look at what we call the dollar cost of annual ownership. This is an analysis that sums together the three costs to get the total dollar cost that you will pay each year to invest in an ETF (including implicit costs). Given the choice of two ETFs that are managed to match the same market, you should pick the one with a lower dollar cost of annual ownership.
Using Dollar Cost of Annual Ownership to Select Between two ETFs
To see how this works, let's suppose that you have a Fidelity account, and that you are trying to decide whether you should own the ITOT iShares Core ETF for your US stock exposure, or whether you should instead own Vanguard's VTI fund. We will use Fidelity's ETF Research tool for all the data.
ITOT is a commission-free ETF at Fidelity. It has a .07% management fee, and a .05% average bid-ask spread. VTI is not commission-free, so it will incur a $8 fee per trade (Fidelity's normal trading rate). It has a .05% management fee and a .01% bid-ask spread.
At first glance, it's difficult to tell which of these ETFs is the better choice. Does the fact that you can buy ITOT without paying any commissions make up for its slightly higher expense ratio and lower liquidity? We can find out by calculating the dollar cost of annual ownership of both funds.
Before getting started, you need to estimate three figures:
- The total amount of money that you will be investing in the fund.
- The number of trades or re-balances that you expect to make each year.
- The overall turnover of the strategy that you are following. This can be interpreted as the percent of your investment that you plan to sell or change each year.
For our analysis, let's say that you have $100,000 invested and that you are planning to make 4 trades a year with 30% overall turnover, figures that would be typical if you were following the IvyVest Dynamic ETF Strategy.
We now can calculate the annual dollar costs of owning ITOT.
- Management Fees: $100,000 x .07% = $70 / year
- Trading Costs: $0 per trade x 4 trades / year = $0
- Implicit Costs: .05% x 30% total turnover x $100,000 invested = $15.
- Total Annual Cost of Ownership: $70 + $0 + $15 = $85
Compare this to the Vanguard fund, VTI:
- Management Fees: .05% x $100,000 = $50 / year
- Trading Costs: $8 / trade x 4 trades / year = $32
- Implicit Costs: .01% x 30% turnover * $100,000 = $3
- Total Annual Cost of Ownership: $50 + $32 + $3 = $85
By sheer coincidence, the dollar cost of annual ownership comes out to the exact same number for both funds ($85). Of course, if you have a different initial investment or a different trading frequency, you will get a different answer.
When it Pays to Compromise on Expense Ratio (or Commissions)
Note that if you were investing more than $500,000, the Vanguard fund would be the clear winner, since the lower cost ratio grows in importance relative to the lower fixed cost of a trade. On the other hand, if you were only planning to invest $25,000 in the fund, the commission fees that you would have to pay with the Vanguard option start to become more significant in relative terms, and you are better off using the iShares fund that you can trade commission-free.
More broadly, the dollar cost of annual ownership framework illustrates a few key takeaways:
- If you trade infrequently, you are usually better off minimizing your annual expense ratio, even if it means paying for trades. This is because the expense ratio, even if it's small, is charged on 100% of your assets every year, whereas you only pay trading costs (implicitly and explicitly) when you actually trade.
- If you have a high turnover strategy, you will want to pay careful attention to both your implicit and explicit trading costs when selecting an ETF. In particular, if your expected turnover is higher than 100%, then differences in the bid-ask spreads of the ETFs can become more significant than differences in their expense ratio.
Most importantly, the right way to select an ETF is to pick one that minimizes your total costs, not to myopically focus just on commissions or expense ratios.
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