As a long-term member of the investment community, I’ve always felt that the best insights any of us have are ideas that improve a client’s investment results. Take exchange-traded fund costs, for example.
Given their structure, the biggest focus on ETFs has been on cost reduction. The first U.S.-listed ETFs introduced by the American Stock Exchange beginning in 1993 were low-cost index funds designed to create a diversified portfolio that traded as a single security on the floor of the exchange. The in-kind share creation and redemption mechanism of most ETFs takes advantage of a tax provision that defers taxation on most capital gains until the investor sells the ETF shares.
While the emphasis on cost reduction has been a constant theme during the industry’s growth, ETF cost calculations are often distorted, and the high costs of using some ETFs tend to be overlooked. An advisor can often reduce costs that are larger than the expense ratio by looking at such areas as:
• The cost differences between the net transaction price of an ETF and its contemporary portfolio net asset value (NAV).
• The costs of fund portfolio composition trades that are front-run by arbitrage desks before a fund can implement an announced change in a popular index.
There are other hard-to-measure ETF costs and hidden transaction costs that are often much larger than the ETF’s total expense ratio, particularly for ETFs holding small-cap stocks, debt securities or securities that are not actively traded at 4 p.m. in New York. (The NAV calculation at 4:00 p.m. is the most accurate value calculation we have for almost any fund traded in the U.S. There is a huge focus on market-on-close trading that is executed as close to the end of the market day as possible, where the closing price is often far from NAV.)
Several colleagues and I wrote a paper earlier this year that examines the trading costs of a variety of ETFs. We found that the bid/ask spread data distributed by many ETF issuers and assorted websites is grossly overrated as a trading cost indicator. One of the leading researchers on ETF trading, Antti Petajisto, has posted a paper estimating that the annual trading premiums investors pay in U.S.-listed ETF buy-and-sell transactions range from $26 billion to $44 billion, depending on assumptions for stale NAVs.
Many things can and should be done to reduce ETF trading costs and improve their transparency. There’s already great emphasis on the transparency of the portfolios’ compositions, but most investors and their advisors will have a better experience if they can achieve full trading cost disclosure as well. Advisors’ fees grow more transparent year by year and are under frequent pressure, but total ETF transaction costs have been growing year by year while getting less transparent.
ETF fund managers know that advisors largely determine their clients’ ETF choices. An advisor who can monitor the relationship between the intraday indicative value (IIV) that ETFs publish every 15 seconds and the current quote spread should be able to reduce client trading costs. This advisor will often be able to buy at a better price when the relationship between the IIV and the best bid and offer indicates that the preponderance of customer orders is on the sell side. With other investors selling, it should be possible to avoid paying very much to a market maker to obtain liquidity for a customer who is a patient buyer of the ETF. Smart trading can add value for the client.
It would be a simple and low-cost operation change for an ETF manager to publish an improved IIV and publish it every five seconds. A good trading desk with access to this improved pricing data should be able to trade at a lower cost to the advisor’s clients.