Why owning the lowest cost ETF does not guarantee you best performance

In general, the lower your ETF fees the better your performance should be. Yet saving a few hundredths of one percent does not guarantee better returns.  

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results

A pricing war in the mainstream exchange traded funds (ETFs), like the FTSE 100, the S&P 500 and the major bond indices trackers, has one major winner: the end investor.

FTSE 100 products in particular have seen significant falls in the total fees charged to investors, with the latest entrant, the Lyxor Core UK ETF, charging a tiny 0.04% a year, or £400 for every million pounds of assets. This makes it 0.03% cheaper than the closest competition. Lyxor has managed to do this in part by benchmarking to the Morningstar UK index, which more than likely charges slightly less in index licensing fees than the FTSE. For investors this is good to see; there is abundant fee competition both from both the index providers and the ETF managers. 

Low fees are here to stay, but what many investors do not realise is that buying the ETF with the lowest fee will not mean that you will automatically outperform an ETF with a slightly higher total expense ratio.

Common ways to compare ETFs

The most commonly analysed metric when buying an ETF is the NAV tracking error. The lower the tracking error, the closer the ETF tracks the underlying market. For example, Bloomberg reports that HSBC FTSE 100 (HUKX) has a tracking error of 0.04%, which is very small indeed.

Securities lending revenue plays a part in your total return, and cannot be offset against the management fee in the total expense ratio (TER) calculation. Some ETF firms do not lend out stock, and others keep different amounts for themselves to cover costs, but it is a source of return nonetheless. The iShares Core MSCI Emerging Markets ETF (EMIM) has a TER of 0.25%, but securities lending revenue of 0.14% covers a good proportion of it.

Tracking difference reflects how closely the ETF’s net asset value has performed, relative to the benchmark. This can be positive or negative, depending on fees, securities lending and manager skill in re-balancing the portfolio to account for benchmark changes. Tracking difference is very important when looking at returns over time, particularly for index funds.

ETFs have two other variables which determine the price you pay. Bid-ask spread and share price premium, and it is the impact of the latter which can be many multiples higher than the headline management fee in the lowest cost ETFs.

Share price premium and discount volatility

This is an issue that is rarely addressed by ETF providers, in essence because it is out of their control. But in a world of very small pricing differences it has by far the largest potential impact on investor returns relative to the benchmark.

Because ETFs trade on exchange, they are subject to price movements from supply and demand. If there are more buyers than sellers, the price could rise above net asset value and vice versa. An ETF that trades at the same time as the market it tracks - such as the FTSE 100 - should have small deviations in price, but there are deviations nonetheless.

In the chart below we can see the daily closing discounts and premiums for iShares Core FTSE 100 (ISF) and Vanguard FTSE 100 (VUKE) over approximately a four year period. Both ETFs distribute their income, but VUKE charges 0.09% a year, whereas ISF charges 0.07%. The ETFs should always trade at a small premium to reflect the creation costs in buying the underlying stock in the market, and in a perfect world there would be no volatility in the premium.

The reality is different. Their relative premiums (calculated by subtracting one from the other) can fluctuate by as much as plus or minus 0.5%. For the investor who buys an ETF on a premium and then sells it on a discount, a low fee is really rather academic. The damage has been done to their relative performance.

Would you be better off trading an index fund instead? Under most scenarios likely not, as index funds have their own creation costs. If you wanted to buy a FTSE 100 index fund, stamp duty costs of 0.5% would be included in your purchase price and that is irrecoverable. This makes them costly to trade in and out of.

ETFs are exempt from stamp duty, but investors do have the frictional cost of the market bid-ask spread. The bid-ask spread is determined by ease of creating and redeeming units as well as the liquidity of the ETF. If many dealers want to make a market in the ETF, the bid-ask spread will be much tighter than if there is one or two. The most liquid ETFs might have a bid-ask spread of 0.03%, while those more esoteric ones could be 0.5% or wider.

What does IG do to reduce trading risks in Smart Portfolios?

IG Smart Portfolios have a sophisticated dealing system that seeks quotes from multiple counterparties, and then selects the best of those quotes to trade. We have found that the weighted average bid-ask spread within portfolios has been 0.05%, which is very competitive indeed. It is not frictionless, but it does mean that re-balancing portfolios has an extremely modest impact on returns.

While we deal throughout the day, we batch overnight orders and cross them at mid-price where appropriate. There are also windows in the day around economic announcements where spreads will widen and we do not trade; similarly portfolios are not traded in a window after the market opens and before it closes.

Trading portfolios is a skill, but to some extent it is akin to a sailing boat waiting for better weather. If market volatility is high, ETF share prices have a greater chance of coming out of sync with net asset values. When volatility is low, share price premiums are more likely to cluster around those averages. It is during those calmer days that we try and make changes to asset allocations. 

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.