Make It Personal: Balance Trading and Holding Costs
Evaluating an ETF’s TCO involves moving beyond just the expense ratio, liquidity profile and trading costs to analyze a combination of technical and process drivers.
Consider the following variables when evaluating ETFs with seemingly similar cost profiles:
- Strategy Type The more strategic an investor or the more strategic the allocation is, the more emphasis should be placed on the cost “hold.”
- Holding Period Depending on how tactical or strategic an allocation is, the holding period can change, underscoring why this should be a separate input.
- Rebalance Frequency The more frequently a portfolio is rebalanced, 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.
Focusing on the part of the TCO equation that has the most impact on your portfolio may lower your costs.
While it’s black and white to stress a fund’s expense ratio for buy-and-hold strategies and trading costs for tactical asset allocations, there are gray areas.
Consider a standard 60-40 core allocation comprised of three ETFs: a US equity, a global ex-US equity and a broad global bond fund. While rebalanced monthly based on a momentum signal, where the portfolio weights are also determined, the assets are strategic and will be held for a long time. Notably, weights do not go to zero given that the model solution is meant to provide broad diversification to global assets.
Here, while holding period and strategy type indicate you should emphasize “holding” costs, frequent rebalancing and uncertain size indicate that you should emphasize “trading” costs. To strike a balance between both cost components, consider establishing a “liquidity” component within the portfolio, where you split asset allocations between the lowest expense ratio and the most liquid funds.
Sometimes You Pay Higher Fees for Lower Costs
Depending on your rebalancing size and frequency, trading costs can accumulate significantly and have a larger impact on the total cost of ownership than any expense ratio difference between two ETFs, underscoring why liquidity analysis has to be a part of any due diligence process prior to implementation. Buying an ETF based on its headline expense ratio alone may not lead to the most cost-efficient solution.