ETFs compete on fees. What else to consider

As investors who use exchange-traded funds know, the cost can be a tiny fraction of the assets you invest.

Sometimes, ETFs from different providers — i.e., Vanguard, State Street, Charles Schwab, etc. — track the same index (say, the S&P 500), which can make it tempting to go with whichever is cheapest. Yet when you choose a fund to invest in, experts say, it’s important to consider more than just its expense.

“ETFs that compete on price are usually index-trackers that charge the cheapest fees in their respective category,” said Dan Sotiroff, a senior analyst at Morningstar. “So, other considerations would ultimately drive the investment decision.”

ETFs have gained traction as an alternative to traditional mutual funds as a way to put money into a basket of investments. Advantages of ETFs include their generally lower cost, greater tax efficiency and intraday tradability. These funds now hold roughly $13.2 trillion in assets, up from $1 trillion at the end of 2010, according to Morningstar Direct.

The cost to invest in a fund is called its expense ratio and is expressed as a percentage of its assets. The average expense ratio for passively managed ETFs — those that track an index and whose performance generally mirrors the index’s gains or losses — is 0.14%, according to Morningstar. For actively managed ETFs — those with a manager at the helm making strategic changes to the fund’s investments — that figure is 0.44%.

Those numbers matter for investors because costs eat into gains, which can have a long-term impact on how much your assets grow.

For instance, $100,000 invested for 20 years with 4% annual growth and a 1% annual fee would end up growing to roughly $180,000, compared with about $220,000 with no fee at all, according to an analysis by the Securities and Exchange Commission. So, the lower the expense ratio, the less the impact on your investment gains.

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While fees are important, there are other aspects to consider when it comes to ETFs, Sotiroff said. That includes the effect of mixing and matching among different ETF providers.

The reason, he said, is that there are subtle differences in how the companies structure their index. For example, if you held a Vanguard ETF focused on large-cap stocks and you wanted to match it with a small-cap ETF, you’d be better off using Vanguard’s offering, Sotiroff said.

“The size breakpoints that distinguish the large- and small-cap segments in those ETFs won’t always line up with the breakpoints on similar ETFs even though they’re going after roughly the same market segment,” Sotiroff said.

For example, mixing one fund company’s ETF with another‘s means you might over- or underweight some stocks and sectors and not get the risk/return exposure that you think you’re getting, he said.

In these situations, “as a general rule, investors should stick with one provider,” Sotiroff said.

Liquidity can matter, too. If an ETF is thinly traded, you could struggle to unload it quickly, and the difference between the bid price (what the buyer is willing to pay) and the ask price (what the seller wants to get) may be greater.

Assess the bid-ask spread and the average daily trading volume, said Kyle Playford, a certified financial planner with Freedom Financial Partners in Oakdale, Minnesota.

“Look for spreads of only a few cents,” Playford said. “Wider spreads can mean less liquidity.”

And, “the higher the [trading] volume, the more liquid an ETF usually is,” he said.

Meanwhile, there may be a better-performing ETF than the one with the lowest expense ratio. For example, you may be able to find an actively managed ETF that outperforms a passively managed index ETF by enough to justify the higher cost if the difference isn’t huge, Playford said.

“We’ve seen opportunities in equity, emerging markets, international, sometimes small- and mid-cap ETFs, where actively managed ETFs have outperformed” passively managed versions, Playford said.

“It is more expensive, but over the long run, you can have an outperformance with active stock picking, especially when markets are more volatile,” he said. The managers “have some ability to trade in and out of the holdings instead of just following the index.”

For example, he said, the Avantis emerging markets equity ETF (ticker: AVEM) is actively managed and comes with a 0.33% expense ratio. Over the last year, it’s up more than 33%. That compares with Vanguard’s passively managed emerging markets stock ETF (ticker: VWO), which has an expense ratio of just 0.07%, but its one-year return is under 25%.