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Liquidity
Evaluate Total Cost of Ownership
Two components make up the total cost of ownership (TCO) of an exchange traded fund (ETF): tracking return difference and investor trading costs. Tracking return difference covers the expense ratio, the portfolio management efficiency in seeking to match the index returns, and the positive offset of any income from lending out underlying securities of the ETF. And, because ETFs are bought and sold on an exchange like stocks, trading costs include the commission and the bid-ask spread.
Expense Ratio: The Fund’s annual management fees that range from legal and marketing expenses to custodial and index licensing fees.
Portfolio Management Efficiency: The revenue earned by the fund for lending out underlying securities. This can potentially reduce, and in some cases offset, the expense ratio or associated portfolio management costs.
Securities Lending Revenue: The revenue earned by the fund for lending out underlying securities. This can potentially reduce, and in some cases offset, the expense ratio or associated portfolio management costs.
ETF Commissions: The service charge by a broker for executing the purchase or sale of a security. Sometimes quoted as a flat fee, or on a per-share basis.
Bid/Ask Spreads: This is the difference between the price a buyer is willing to pay for shares and the price at which a seller will sell.
Source: State Street Global Advisors
It’s necessary to look beyond the expense ratio when evaluating TCO.
Focusing on the part of the TCO equation that has the most impact on your portfolio may lower your costs. When evaluating ETFs with similar cost profiles, consider your:
- Investment Strategy: For a strategic allocation, focus on the expense ratio, or the cost to “hold” the ETF. For tactical allocations, trading costs come more into play.
- Rebalance Frequency: The more frequently you rebalance, the more emphasis is needed on the costs to trade, even if it is a “strategic allocation".
- Portfolio Turnover: When the size of the turnover increases, so do trading costs