When choosing from the more than 2,000 US-listed exchange traded funds (ETFs), there are four major areas of due diligence: cost, risk/return, holdings make-up, and tracking accuracy for index-based strategies or the manager’s investment process for active funds. While the last three are often heavily scrutinized, many analyze cost more simply, focusing solely on an ETF’s expense ratio. However, it's important to evaluate an ETF's total cost of ownership (TCO).
Low Expense Ratios Don’t Always Mean the Lowest TCO
Because an ETF can be bought and sold on an exchange like a stock and incurs trading costs, your TCO evaluation should include both trading and holding costs. Low fees do not naturally lead to low trading costs and, therefore the lowest TCO. Figure 1 plots the 30-day average bid-ask spread versus the expense ratio for the 100 largest US equity ETFs, clearly illustrating the lack of correlation between ETFs’ expense ratios and trading costs. As shown, as a result of differences in secondary market liquidity profiles, some higher fee funds have lower bid-ask spreads, and some lower fee funds have higher bid-ask spreads.