Exchange traded funds (ETFs) have surged in popularity in large part due to the low fees they promise for access to investable indexes. But many ETF investors pay much higher fees than what’s apparent from the advertised expense ratio, finds Paul Amery of IndexUniverse (“Beyond the Expense Ratio” Yahoo Finance, 2/2/11).
This applies to both passive and active ETFs. For active strategies, high turnover can cause performance drag that’s never fully apparent to the investor. Amery (emphasis added):
academic studies based on the activity of UK equity funds suggest that a turnover rate of 100% a year adds around 1% to the ultimate costs faced by an investor… the new Man GLG Europe Plus Source ETF, launched this week, follows a computer algorithm to select from amongst the stock trading ideas generated by the European brokerage community. According to Sandy Rattray, head of Man Systematic Strategies, the index’s implied internal turnover levels are likely to exceed 1000% per annum.
For passive ETF investors, index rebalancing can weigh on returns in a manner that’s effectively an additional cost for shareholders, but again, never seen:
According to a 2008 academic study by Antti Petajisto of Yale University, price distortions resulting from indices’ reconstitution resulted in a turnover drag of at least 0.38%-0.77% a year for investors in the Russell 2000 index and at least 0.21%-0.28% a year for the S&P 500 index (taking two widely followed capitalisation-weighted benchmarks), measured over a fifteen year period from 1990-2005. Other studies have suggested that the turnover drag might be even larger.
Then there are the new hedge fund strategy ETFs, which seem to be the worst infractors. These funds bury a whole host of fees – cost of borrowing, risk monitoring charges, underlying fund management and performance fees, and ETF managment fees – right within the benchmark. For this reason, investors in the db x-trackers hedge fund index ETF, for example
could easily face 4-5% in overall charges on an annual basis. These fees are not hidden – they’re in the prospectus. But neither would you realise that they were there if you only looked at the TER [Total Expense Ratio].
At Covestor, there are no hidden fees – just a straightforward managment fee and brokerage charges that are always fully apparent to our clients. We believe investors deserve far greater transparency on investment fees than the fund management industry generally provides.
