The Hidden Costs of Investing in Index Funds & ETFs
Today’s topic covers the confusion around the costs of owning various types of investments.
By Louis B Llanes, CFA CMT
Founder, Wealthnet Investments, LLC
There’s a lot of confusion surrounding the costs of owning various types of investments. When you look at the news you see a sort of race toward zero. You see very large brokerage firms saying they’re going to sell you this exchange traded fund for zero cost and no fees associated with it, no transaction costs.
There is no free lunch. We all know there must be costs so in this article I’m going to break it down. Towards the end I’m going to outline why we like to invest in individual stocks rather than buying packaged products.
The Hidden Costs of Exchange Traded Funds and Indexing
As an example, to illustrate the costs of exchange traded funds and other “low cost” investing, we’re going to look at three of the largest exchange traded funds that track the S&P 500. There’s a big craze for indexing and a lot of investors want to own funds that track the indexes. If you look at the funds that track the indexes, they underperform the index too!
The first ETF we’re looking at is the ($SPY), or SPDR S&P 500 ETF, which has been around the longest in this category. Looking at this chart we see the performance of the S&P 500 itself as the green line, the unmanaged index as a total return index. Underneath that is two more values that are very close together – one is the asset value, which is the net asset value returns of the SPY ETF, and the other is the total return which includes changes in price and dividends.
The first thing you see is how much less over time you've earned as an investor owning a passively managed exchange traded fund compared to the S&P index itself. Why is that?
…because of frictional costs such as expense ratios, hidden bid/ask spreads, market impact costs of trading.
What Advertisers of Funds Don’t Tell You
Premiums, Discounts, and Brokerage
This next chart is for ($IVV) S&P 500 ETF and you can see a similar spread when compared to the S&P 500 total return index. If you look at the bottom half on each one of these graphs, you'll see that there is a blue bar chart which shows monthly premium and versus the net asset value. This is the difference between the price investors are executing trades compared to the underlying worth of the holdings. You can see variances through the months.
When you buy an exchange traded fund, you are still dealing market impact costs. These are costs that occur from the prices moving against you when you enter the market. This is especially costly for investor that trade larger dollar amounts – like institutional ETFs and Mutual Fund managers. I’ve heard many people say that ETFs don’t have very little market impact costs. This of course depends on the fund but there is a significant cost there. Bottom Line: there is a spread between what the net asset value is in the marketplace and the execution price of investors.
What graph shows is the average of this price difference in percentage terms. The difference could be in your favor or not. A conservative assumption would be that it's not going to be in your favor, but that's another thing you've got to consider.
The Index Outperform the Index Funds
Let’s break this down and look at the five- and ten-year annual returns in the table below. The first thing is you'll notice is that all of the ETFs underperform the index. The total cost of ownership is the difference between the index returns and the fund returns.
There are two categories of costs in the index funds. First is the holding costs. Holding costs include the expense ratio, the bid/ask spread, brokerage commissions, taxes, and most importantly, market impact costs. Notice that some costs are hidden and not disclosed. That would include the bid/ask, the market impact, brokerage commission, exchange fees, and taxes charged by some countries.
If you look at the expense ratios, the $SPY has an expense ratio of nine basis points. $IVV and $VOO both have an expense ratio of four basis points.
If you look at the annual holding costs, you can see that that, over a 10-year period of time, the SPY cost of ownership was 13 basis points per year.
Market Cap Weighted Indexes Can Invest More Money in Expensive Stocks
When you invest an index fund it probably is weighted by market capitalization. Market capitalization is the number of shares outstanding of a company multiplied by the price. By definition, this scheme will tend to invest more money in larger more pricier stocks. In long extended bull markets, these stocks can be very expensive and due for a correction.
The S&P 500 index, is a market cap weighted strategy. This means that you're basically assuming that I want to put more of my money in those companies that are worth more in the market today. That is sometimes a great strategy, especially when you have a bull market. Other times it's a very poor strategy, particularly when the market starts correcting. This is because you tend to have more of your money is those expensive companies toward the top of the list and there can be really sharp corrections.
Why Directly Owning Stocks Can Be Better
Let's compare investing in the index ETFs to owning stocks. If we own stocks, we have the ability to be active and we can customize and go after alpha factors. We can try to find those companies with stronger valuation, better quality, trends, and momentum. This could give the investor an edge in the market. But can this edge overcome the costs of trading?
Cost Comparison of Stocks Versus Index ETF
We’re now going to isolate the costs of trading a stock portfolio for different size investors. The real issue when it comes to whether or not you invest in individual stocks has to do with how much money you have and how much you're going to allocate to equities in your strategy. In this case, I'm going to show two strategies - one with 30 stocks and one with 50 stocks.
There's a lot of research out there that shows that you can get most of the diversification with 30 - 50 stocks; One study in particular says roughly 90% of your diversification benefits are derived if you have 50 stocks.
This table shows the costs of owning a portfolio of 30 stocks that is actively traded. The costs are calculated assuming you turn over 30% of your portfolio each year. It assumes a commission cost of $1 which is very realistic today. Although some discount brokers are still charging more, you can find large reputable brokers charging less. At some of the brokerage firms you can still pay much more than which adds up.
Cost of Turnover
Let's assume we're going to be more active and we're going to have 30 percent turnover.
So we're going to turnover roughly a third of our portfolio every year and we're going to pay a bid-ask spread. Anytime you invest in stocks, you are going to be paying that bid-ask spread. If you're a smaller investor, the market impact costs could be zero. However for this scenario, we’re going to say everybody's going to pay market impact costs and they’re going to be 10 BPS. Using 10bps is reasonable given that we are investing in liquid large companies. Obviously, if you trade smaller companies or if you're trading international stocks there will likely be a larger impact cost.
Compare stock portfolio costs to the ETFs. We are being conservative and estimating total cost to be 7bps for ETFs. We estimate this using the Morningstar Direct database estimated holding costs.
Cost of Initially Investing
There are initial brokerage costs when you establish the stock portfolio, so we account for this. We estimate that brokerage costs and discount them back over a 10-year holding period at three percent.
No Expense Ratios in Stocks
We include the bid-ask spread in the market impact costs and holding costs of commissions from the turnover. Putting these together we get the total cost of investing in stocks. Notice that there are no expense ratios in the cost. That of course is due to the fact that there are no expense ratios charged by stocks.
Break Even Cost of Direct Stock Ownership
If you look down the Cost Compare column, you will see that the larger the portfolio the more edge is gained from owning stocks directly. Let’s look at a $10,000 portfolio as an example - it's pretty expensive. It's 84 basis points to have a portfolio of 30 stocks that you turned over 30 percent per year. You probably wouldn't want to do that unless you have a big edge.
On the other hand, if you have $100,000 you're off by about five basis points. If you have $250,000, you’re basically at a break even compared to a passive index, even though you're trading more. You can see how these numbers work out, especially in liquid instruments where it becomes the investor’s advantage, if you’re active, to own the individual securities directly.
If you go to $500,000 or a million dollars, you actually get a cost advantage and if we're applying alpha strategies like momentum and value, then we have the opportunity to have 200+ basis points of outperformance. If we buy the index ones, we're accepting the average and we aren’t giving ourselves an opportunity to do better.
The numbers look different if you have 50 stocks - the breakeven is higher, around $500,000. If you wanted to, you could buy a representative sample of the stocks of the index and not trade it as often, more like a 10 percent turnover, and you would have even better-looking numbers.
The advantage is even greater if you compare it to mutual funds because not only do the mutual funds have the issue of the visible and invisible costs, but they also have some poor taxation issues and they generally have higher expense ratios.
Summary off Cost Difference Between ETFs, Direct Stock Ownership, and Mutual Funds
This table shows the attributes of ETFs, mutual funds, and stocks, and compares them piece by piece. For example, we have the visible costs - those would be the initial commissions and admin costs. Then we have the bid ask costs, which everybody is going to pay, no matter what strategy.
There are also invisible costs that you don't see, but still need to be factored in. Trading costs, for example, from your turnover. Those are invisible for ETFs and mutual funds, but visible for stocks.
As for the expense and admin costs, the institutions that are trading larger dollar amounts will pay less than the retail trader or investor, but they're still there. However, if you have stocks, you don't have that cost.
Giving Up Versus Attempting to Gain Better Returns
If you buy the indexes you have to accept a market cap weight; that's just the nature of it. There are some fundamentally weighted indexes, some value and momentum weighted, too that could be exceptions, but it’s not the general rule. Academic research has found that factors such as valuation, momentum, quality, and trend can improve results in the context of a diversified portfolio.
3 Strikes and You’re Out: Closet Indexing, Higher Fees and Unnecessary Taxes
In my opinion there are three strikes against owning many mutual funds. Many mutual funds are closet indexers with higher fees and taxes. If you look at the number of stocks that many of mutual funds own, they own so many stocks that they replicate the index very closely. To make matters worse, many have higher fees. That is two strikes. The third strike again mutual funds is that they can spin off unnecessary gains. Because of their structure, unrealized capital gains earned by other investors could be distributed to newer shareholders – not a good thing.
Direct Stock Ownership: Gain Customization, Tax Control and Diversification
With stocks, we have flexibility. We can pursue better quality, valuation, and trends. We can diversify well and customize the portfolio to meet individual investor needs. The cost difference is negligible and could even be an advantage over funds, especially mutual funds.
An investor that has $250,00 or more may consider to invest in stocks. If you have over $500,000, I would say you should be looking at using individual stocks with a disciplined strategy.
How Many Stocks are Enough for Diversification?
This graph looks somewhat complicated, but it's a simple concept is concept and it deals with diversification. It’s from a really interesting article, Equity Portfolio Diversification: How Many Stocks are Enough? It was a white paper with evidence from five developing markets, and there are a lot more that we could choose from that would show a similar result.
This specific one shows that if you get your number up to 50 stocks, you really get close to diversifying away what's called an “idiosyncratic risk” or the risk of an individual security.
Essentially, you can get that diversification with 50 stocks. With 30, you're getting really close, but the larger number is more ideal.
Tax Consequences and Benefits
I want to touch on the tax consequences briefly. One of the beautiful things about owning individual stocks and ETFs, is the tax benefits. In some ways, ETFs have better tax benefits because you can wash gains out. If you're in a tax-free account or a tax deferred account, you have more of a reason to have mutual funds or individual stocks. Even then, I think individual stocks and ETFs win out.
There was a study done by research affiliates and it was done with the same data set that we do, which is Morningstar direct. There was a portion called Is Your Alpha Big Enough to Cover Its Taxes, shown above. It essentially shows that ETFs do, in fact, have some tax advantages.
In summary, there is no free lunch. Don’t let the marketers fool you. There are costs with indexing, mutual funds, and exchange traded funds. Many of these costs can be outweighed by the benefits of direct stock ownership if investors use a disciplined smart approach.
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