{"id":1282,"date":"2020-08-17T14:37:32","date_gmt":"2020-08-17T18:37:32","guid":{"rendered":"https:\/\/www.etfrc.com\/articles\/?p=1282"},"modified":"2020-08-17T14:38:16","modified_gmt":"2020-08-17T18:38:16","slug":"the-true-costs-of-u-s-sector-etfs","status":"publish","type":"post","link":"https:\/\/www.etfrc.com\/articles\/index.php\/2020\/08\/17\/the-true-costs-of-u-s-sector-etfs\/","title":{"rendered":"The True Costs of U.S. Sector ETFs"},"content":{"rendered":"\n
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Beware Bargain “Headline” Fees That Can Cost You More In The End<\/p>\n\n\n\n

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Below is a reprint of a white paper entitled “U.S. Sector ETF Suites: A Look at Total Cost of Ownership” that examines the real cost differences between four competing domestic sector ETF lineups from Sector SPDRs, Vanguard, iShares and Fidelity. <\/em> You can download the PDF version here:<\/em><\/p>\n\n\n\n

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Executive Summary<\/p>\n\n\n

\u2022 Sector ETF suites enable investors to tactically allocate to sectors they believe are poised to perform well in various stages of the economic cycle. We examine the total cost of ownership (TCO) associated with four major sector ETF suites: Sector SPDRs, Vanguard, iShares, and Fidelity.<\/strong><\/p>\n

\u2022 Investors who focus on funds\u2019 expense ratios while ignoring bid\/ask spreads are missing an important part of the total cost picture and making a potentially expensive mistake. This is particularly applicable to trading vehicles like sector ETFs.<\/strong><\/p>\n

\u2022 A comparison between the Vanguard sector suite and the Sector SPDRs\u2014the two low-cost leaders overall\u2014shows that Vanguard\u2019s cost advantage from its funds\u2019 lower expense ratio is negated by wider bid\/ask spreads in normal markets. In stressed markets spreads can grow much wider, negating the fee advantage several times over (Figure 1).<\/strong><\/p>\n

\u2022 The holding period required for a Vanguard sector ETF\u2019s lower expenses to compensate for wider bid\/ask spreads in normal markets is one year. If just one side of the ETF trade (purchase or sale) occurs during stressed markets, the breakeven holding period can grow to 3.2 years.<\/strong><\/p>\n\n\n

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Sector Suites: An Overview<\/p>\n\n\n\n

Sector\nETF suites tracking traditional, market cap-weighted indices are available from\nfour major issuers: State Street, under the \u201cSector SPDRs\u201d brand; Blackrock,\nunder the \u201ciShares\u201d brand; Vanguard and Fidelity (Table 1). <\/p>\n\n\n\n

Sector SPDRs are the most established. The original nine funds have more than 20 years of trading history since inception in December 1998 (XLRE<\/a> and XLC<\/a> debuted in 2015 and 2018, respectively, coinciding with evolving sector definitions. The iShares suite came along about a year and a half later, in mid-2000, followed by Vanguard (2004) and Fidelity (2013).<\/p>\n\n\n\n

The funds\u2019 track different indices so their constituents are not identical, though there is considerable overlap. (To see the overlap between any two ETFs use this tool<\/a>.) The Sector SPDRs collectively hold the constituents of the S&P 500 index of large cap stocks, divvied up according to each constituent\u2019s sector designation under the Global Industry Classification Standard (\u201cGICS\u201d). Vanguard, iShares and Fidelity track similar broad, market-cap weighted indices from MSCI and Dow Jones, which are dominated by large caps but that also include some exposure to mid- and small-caps. <\/p>\n\n\n\n

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A More Complete Cost Analysis <\/p>\n\n\n\n

Investors seem predisposed to focusing on ETFs\u2019 expense ratios while deemphasizing other costs associated with ETF investing, which in some cases can exceed the \u201cheadline\u201d expense number. All ETF prospectuses, for example, contain a discussion of these management fees, along with examples of how these costs might add up over time. And ETF issuers have been engaged in a well-documented \u201cfee war\u201d over the last few years in an effort to draw in new assets, including from competitors. <\/p>\n\n\n\n

The\nExpense Ratio<\/strong> is the management fee the fund company charges\nshareholders. This generally fixed fee is the \u201cheadline\u201d cost that is easy to\ncompare between funds. But management fees are not the only costs ETF investors\nmust bear.  <\/p>\n\n\n\n

ETF\ninvestors also pay via the Bid\/Ask Spread<\/strong>\neach time they purchase or sell an ETF. This cost can vary widely across ETFs\nand according to market conditions, making fund comparison more difficult.\nNonetheless it is important to consider as it can sometimes amount to more\u2014much\nmore\u2014than the expense ratio. \n\nThis is particularly applicable to funds such as\nSector ETFs, which many investors view as tactical trading vehicles as opposed\nto long term, buy-and-hold investments. The more frequent the trading, the more\nthese costs add up. It is these two costs\u2014Expense Ratios and<\/em> Bid\/Ask\nSpreads\u2014that we will examine together in evaluating the Total Cost of Ownership[1]<\/a>\n(\u201cTCO\u201d) of our four sector ETF product suites.\n\n
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Expense Ratios<\/p>\n\n\n\n

Table 2 lays out the average annual expense\nratios of our four sector ETF suites. Three of the sector suites\u2014SPDRs,\nVanguard & Fidelity\u2014are what we would group as \u201clow cost\u201d providers. Sector\nSPDRs have an expense ratio of 13 basis points, while the Vanguard suite\naverages 10.2 basis points (all Vanguard funds charge 10 bp except the Real\nEstate fund, which charges 12 bp). Fidelity is cheaper still at just 8.4 basis\npoints. Meanwhile iShares charges significantly higher fees for their sector\nsuite at an average of 42.2 basis points.<\/p>\n\n\n\n

Bid\/Ask Spreads<\/p>\n\n\n\n

There are many things that determine an ETF\u2019s\nbid\/ask spread, including trading volume of the ETF, liquidity of the\nunderlying shares, and ease of hedging by market makers. While not usually as\nhigh as an ETF\u2019s expense ratio, the bid\/ask spread varies with market\nconditions, just as it does with single stocks. To evaluate the bid\/ask\ncomponent of an ETF\u2019s costs therefore we use an average of bid\/ask spread\nobservations over time. Table 2 shows these averages for each of our sector ETF\nsuites.<\/p>\n\n\n\n

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The figures above are from the month of June 2020, representing well-functioning markets when volatility was at levels well within historical norms. When volatility spikes and markets are stressed like during the COVID sell-off earlier this year\u2014precisely the kind of environment in which sector investors might want to make a few trades\u2014bid\/ask spreads can increase dramatically. <\/p>\n\n\n\n

The difference in how our four sector suites fared during this period might be eye-popping. While the Sector SPDRs saw its suite-average spread hit a maximum of 6 basis points, Vanguard funds (whose red line on the graph is mostly behind iShare\u2019s gray line) saw spreads spike to a high of 35 basis points. iShares and Fidelity recorded even higher maximum spreads of 43 and 46 basis points, respectively (Figure 3). <\/p>\n\n\n\n

Of course, most traders did not trade at the exact most disadvantageous time. To get an idea of more typical costs incurred by trading in volatile markets, we simply took an average of the daily bid\/ask spreads observed during March 2020 (Figure 3). Here we see that the differences in spreads grew to be much greater than any difference in expense ratios.<\/p>\n\n\n\n

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TCO:\nExpense Ratio Plus<\/em> Bid\/Ask Spreads<\/p>\n\n\n\n

To examine the total cost of ownership for our sector ETF suites we need to add each suite\u2019s average bid\/ask spread to its average annual expense ratio. This represents the total cost an investor could expect to pay from purchasing the ETF, holding it for one year, and then selling it (we will consider other time frames later). Figure 4 shows these figures for each sector suite under normal market conditions, utilizing average bid\/ask spread data from June 2020. <\/p>\n\n\n\n

Under this scenario, the SPDRs and Vanguard sector suites are TCO leaders, tied with total costs of $14.90 for every $10,000 invested, followed closely by Fidelity at $15.50.  iShares has far higher total costs at $47.00 per $10,000 invested. <\/p>\n\n\n\n

But when market conditions become volatile, it is no longer a close contest between SPDRs, Vanguard and Fidelity. Using average bid\/ask spread data from March 2020, the total cost of ownership for the Sector SPDRs suite increases about 9% to $16.22 per $10,000 invested, while TCO for the Vanguard suite nearly doubles, to $28.39. Fidelity and iShares see large increases in TCO as well (Figure 5). <\/p>\n\n\n\n

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Looked at another way, and focusing on the two cost leaders, we see that under normal market conditions Vanguard\u2019s low-expense advantage is negated by its funds\u2019 wider bid\/ask spreads. And under stressed market conditions, Vanguard\u2019s much wider bid\/ask spreads completely overwhelm their lower-fee advantage (Figure 1).<\/p>\n\n\n\n

Holding\nPeriod Analysis<\/p>\n\n\n\n

We have seen how a fund\u2019s bid\/ask spread can affect a fund\u2019s total cost of ownership. In the case of Vanguard and Fidelity, these suite\u2019s wider bid\/ask spreads can overwhelm their cost advantages on the expense ratio versus that of the Sector SPDRs. However, since bid\/ask spreads are only incurred when trading, the longer an investor holds a fund the more important its expense ratio becomes to the TCO picture, and the less important bid\/ask spreads become. <\/p>\n\n\n\n

So,\nwhat time horizon does an investor need to have in order to make holding a\nlower-fee\/higher-spread ETF cheaper in terms of overall costs, versus a\nhigher-fee\/lower-spread competitor? We compared the Vanguard and Sector SPDRs\nsuites\u2014the two closest competitors in terms of overall costs\u2014under two\nscenarios. <\/p>\n\n\n\n

In\nthe first scenario, we assume bid\/ask spreads that reflect normal market\nconditions. In the second, we assume an entry trade under volatile market\nconditions with the elevated bid\/ask spreads that accompany them, but we assume\nmarket conditions have returned to normal by the time we go to sell.<\/p>\n\n\n\n

In the first scenario, as we enter into an initial $10,000 investment, we will expect to have paid about $0.96 to purchase the Sector SPDR ETF (i.e., half of the Sector SPDRs\u2019 average bid\/ask spread of 1.9 basis points) and about $2.37 for the Vanguard fund (half of Vanguard funds\u2019 average spread of 4.7 basis points). Thereafter, fund expenses will start to add up at a rate of about $1.08 per month for the Sector SPDR fund but just $0.85 per month for the Vanguard fund. <\/p>\n\n\n\n

After six months, total costs incurred from owning either of the funds is equal. However, any gains in the account are still unrealized. Investors need to hold the funds for another six months in order for savings on Vanguard\u2019s lower expense ratio to compensate for the higher costs expected to exit the trade. Overall, then, the holding period required for the Vanguard sector funds to gain a TCO advantage over the Sector SPDRs is at least one year under normal market conditions (Figure 6). <\/p>\n\n\n\n

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That\nholding period lengthens dramatically if just one side of the trade takes place\nunder volatile, stressed market conditions. In the second scenario, the cost to\npurchase the Sector SPDR ETF is estimated to be about $1.61 (i.e., half of the\nSector SPDRs\u2019 \u201cstressed market\u201d bid\/ask spread of 3.2 basis points). For the\nVanguard fund however, that cost is expected to rise to about $9.10 (half of\nthe 18.2 basis point spread).<\/p>\n\n\n\n

It\nwill take 32 months for the Vanguard fund\u2019s expense ratio to compensate for\nthat initial \u201chit\u201d from the bid\/ask spread, and an additional six months to\ncompensate for the expected costs of exiting the trade, assuming market\nconditions and spreads have returned to normal levels by then (Figure 7). This\nbreakeven holding period then is 38 months\u2014more than three years!<\/p>\n\n\n\n

Parting\nThoughts<\/p>\n\n\n\n

Investors\nare remiss to neglect bid\/ask spreads when evaluating ETF costs. This is\nparticularly true with tactical trading vehicles like sector funds. Examining\nthe sector product suites from major ETF issuers, we found that wider spreads\ncan negate any cost advantage on the expense side even in normal market\nconditions. In especially volatile conditions it may take years to overcome the\n\u201chit\u201d from just one trade made with wide spreads. For most investors who are\nlikely to trade at least once a year, the Sector SPDRs remain the total<\/em>\ncost leader among sector suites.<\/p>\n\n\n\n

[1]<\/strong><\/em><\/a> <\/em>Many analysts also consider Trading Commissions and\nTracking Error part of the ETF Total Cost of Ownership. However, they are\nomitted from this analysis for several reasons. Many brokers now offer commission-free\nETF trading; and tracking error is neither a cash cost nor does it have a\ndirectional indicator (beating a benchmark by 1% \u201ccosts\u201d the same as trailing a\nbenchmark by 1%).<\/em><\/em><\/p>\n","protected":false},"excerpt":{"rendered":"

Investors who ignore bid\/ask spreads can be making an expensive mistake. In normal markets spreads can negate any difference in expense ratios, while in volatile markets spreads can swamp fee differences several times over.<\/p>\n","protected":false},"author":2,"featured_media":1306,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[6],"tags":[4,244,238,239,240,241,141,242,243,236,237,245,13,219,8,9,12,15,23,14,16,11,32],"class_list":["post-1282","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-sector-etfs","tag-spy","tag-vaw","tag-vcr","tag-vdc","tag-vde","tag-vfh","tag-vgt","tag-vht","tag-vis","tag-vnq","tag-vox","tag-vpu","tag-xlb","tag-xlc","tag-xle","tag-xlf","tag-xli","tag-xlk","tag-xlp","tag-xlre","tag-xlu","tag-xlv","tag-xly","description-off"],"_links":{"self":[{"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/posts\/1282","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/comments?post=1282"}],"version-history":[{"count":40,"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/posts\/1282\/revisions"}],"predecessor-version":[{"id":1331,"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/posts\/1282\/revisions\/1331"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/media\/1306"}],"wp:attachment":[{"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/media?parent=1282"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/categories?post=1282"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.etfrc.com\/articles\/index.php\/wp-json\/wp\/v2\/tags?post=1282"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}