Expense Ratios - Is your ETF changing on you?

January 29, 2008

SAN DIEGO (ETFguide.com) - The popularity of exchange-traded funds (ETFs) is no mere accident. More investors are beginning to understand the importance of using the right financial products to build their investment portfolio.

While lower fees, minimal taxable distributions and trading flexibility are all important attributes of ETFs, let’s focus on one aspect of financial cost associated with ETF investing; a fund’s expense ratio.

The expense ratio is defined as the percentage of a portfolio’s average net assets used to pay its expenses. Among the costs included in a fund’s expense ratio are management fees, administrative fees, and 12b-1 marketing fees. Even though these fees aren’t necessarily billed via a monthly invoice, they are a significant ongoing cost that directly reduces investor returns. 

It should be the goal of every mutual fund and ETF investor to minimize the wealth eroding impact of fund expenses to the greatest degree possible. From an investor’s perspective, high expense ratios are bad while low expense ratios are good. Therefore, identifying ETFs that carry rock bottom expenses is a good place start in building the foundation of an investment portfolio.

Among educated investors, it’s largely known that actively managed mutual funds carry higher expense ratios versus corresponding bond and equity ETFs. In many instances, index ETFs beat index mutual funds when it comes to expense ratios.

Recently, the Vanguard Group, which manages 37 ETFs, lowered the expenses on three of its popular international ETFs. (See Table 1)

Table 1: Vanguard ETFs

* Category = Emerging Markets
** Category = International Regional
#  Security Selection: Passive / Security Weighting: Market Capitalization

Table 1 also illustrates ETF expense ratios from two perspectives; a fund’s category average and its corresponding index strategy average.

Comparing expense ratios to a fund’s category average is a popular way to measure ETF expenses for funds in the same investment universe. For example, according to ETFguide.com’s database, the average expense ratio for all equity emerging markets ETFs is currently 0.55 percent. Look at this number a point of reference. Put another way, emerging markets ETFs with expense ratios lower than 0.55 percent probably offer investor’s a better value.

Another way to evaluate ETF expense ratios is according to their index strategy. In Table 1, all of Vanguard’s ETFs listed follow an index strategy that selects stocks passively and weights them by market capitalization. As noted, ETFs that follow this same exact index strategy typically charge 0.33 percent to own. The data shows that Vanguard’s Emerging Markets ETF (Ticker: VWO), Vanguard European ETF (Ticker: VGK), and the Vanguard Pacific ETF (Ticker: VPL) carry expenses substantially lower versus ETFs not just in the same fund category, but to funds that use the same index strategy. 

It’s important that investors evaluate ETF expense ratios not just by traditional measures, like fund category averages, but by new measures like index strategy averages. Up until now, it’s been impossible to know the average cost ETF index strategies. ETFguide.com’s online database reports ETF expense ratios from both perspectives.

One last thing to keep in mind is temporary fee reductions or waivers. For example, the PowerShares lineup of  Dynamic Portfolio ETFs have an integrated provision (Prospectus, page 97) which allows for a fee increase after April 30, 2008. Currently, the expenses are capped at 0.60 percent but could change after April 30^th.

Many new ETFs introduced over the past year also have temporary fee reductions. Even though investors may be enjoying lower expense ratios right now, those reduced costs may not necessarily persist in the future. If you own any ETFs, it’s a good idea to check the prospectus to find out if your fund has any fee waivers and when they expire.