Finding the lowest-cost exchange-traded product, or ETP, entails more than simply seeking out the one with the lowest expense ratio. The expense ratio is just one component of the total cost of ownership, which can be broken down into trading costs and holding costs.
Investors have some degree of control over trading costs, which are made up of things such as the brokerage commission, the bid-ask spread, and the price impact resulting from large trades. On the other hand, the ETP's sponsor and the portfolio manager are largely responsible for the holding costs. In aggregate, holding costs measure an ETP's benchmark-relative performance. The expense ratio tends to be the largest, most explicit, and most stable component of the total cost of holding an ETP.
However, there are other factors to consider, including implementation shortfall on the part of the portfolio manager and any potential offset from securities lending. Holding cost is easy to measure, as it entails comparing an ETP's performance with the performance of its benchmark index. In contrast, trading costs can be more difficult to measure.
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Trading costs can become a more important consideration for short-term traders who will pay the entire cost of buying and selling an ETP but shell out just a fraction of the fund's annual expense ratio. Trading costs are also of particular importance to investors moving a large percentage of a fund's average daily trading volume. The more liquidity that an investor demands (as measured in terms of frequency or trade size), the more significant trading costs are as a component of the total cost of ownership.
One of the biggest components of trading costs is the bid-ask spread. The bid-ask spread is the difference between the highest price an investor is willing to pay for an ETP's shares (the bid) and the lowest price at which a seller is willing to part with them (the ask). This amount is pocketed by a market maker as compensation for matching buyers and sellers.
In assessing liquidity, it is important to assess both the liquidity of the ETP itself (using measures like the bid-offer spread and trading volume) as well as the liquidity of its underlying assets (blue-chip stocks are more liquid than bank loans, for example). Taken together, these factors help to explain the ETP's bid-ask spread.
Morningstar calculates an equal-weighted average of each of the unique best bid-ask spreads quoted throughout the trading day. Analyzing the data, a few clear trends emerge. First, in general, the more assets an ETP has the more liquid it will be. The table below shows the average bid-ask spread as a percentage of an ETP's price for 1,709 U.S.-listed ETPs. I calculated the average over the 30 trading days through 19 June 2015. During this period, the average bid-ask spread among the 41 ETPs with more than $10 billion in assets was just 2 basis points. When estimating the total cost of an ETP, the cost represented by the bid-ask spread could be amortized over the holding period. Therefore, the longer the holding period, the less meaningful a component of the total cost of ownership the bid-ask spread will be.
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The second pattern that emerges from the data speaks to the relationship between an ETP's bid-ask spread and the liquidity of its portfolio constituents. The next table shows the median bid-ask spread by category group. Here, I chose the median rather than the average as there are many ETPs with low asset levels, which results in an upward skew to the equal-weighted average bid-ask spread. As we would expect, ETPs that track benchmarks composed of very liquid underlying securities, such as U.S. stocks, have tighter spreads than those tracking less-liquid securities (bonds) or those that trade on exchanges whose local market hours have little or no overlap with U.S. trading hours (international stocks).
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In part two of this article, we will take a look at the other real life examples.
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