When you are choosing an ETF for you investment portfolio probably the most important consideration is 'fit for purpose' or is the ETF likely to deliver the type of return I am seeking. The second most important consideration should be cost. The headline cost is the management expense, the amount expressed as a % of your investment amount that the manager charges to manage the funds. But that is not the only cost of buying and holding an ETF. This article will have a closer look at all the costs you should be aware of.
To start with let's just list and name the costs;
The management expense including;
management fee
recoverable expenses
indirect costs
The buy/sell spread (when you buy the ETF)
The buy/sell spread (when you sell the ETF)
The brokerage fees (when you buy the ETF)
The brokerage fees (when you sell the ETF)
Operational and transaction costs of the fund
Any performance fee that may apply
Tax including;
capital gains tax
tax on distributions
I think that about covers it! So let's take them one by one.
The Management Expense
This is the cost the manager of the fund charges you to invest your funds. The managers of the funds all calculate this slightly differently so it is worth looking at individual Product Disclosure Statements (PDS's) which you will find in the details for each fund on Accument. Generally the management expense can be broken down into a management fee, recoverable expenses and indirect costs. These are all included in the headline management expense.
The management fee is the cost paid to the manager to manage the funds.
The recoverable expenses are expenses such as custodial fees, fund administration, registry, ASX fees and audit costs.
Indirect costs are amounts that the fund is allowed to deduct that don't fall into the above categories. In many cases the indirect costs will be zero or very small amounts. Management expenses vary greatly from the lowest, VTS (US Total Market ETF, watch out for this one later!) at .03% per annum to the highest, MAAT (Monash absolute active fund) at 2.26%.
Generally speaking active funds charge more than passive or index linked funds which makes sense because they employ people to make decisions about the funds assets. Then funds that invest in difficult parts of the world, like China or Korea charge a bit more and funds that invest in small companies charge a bit more.
Watch out for geared funds. The headline management fee is based on gross funds so for instance GGUS (Geared US fund) has management expenses of 0.80% but actually the fund may be geared 3 x so the fee that you pay is more like 2.40%. Watch out for them in Operational costs too!
The chart below can be found in our Analysis charts section. The darker blue section is headline management expenses. This is global shares there is another chart for Australian and Fixed Income.
The buy/sell spread
When you buy an ETF and when you sell that ETF you do so by transacting on the stock exchange. Much of the time you will be buying from or selling to a Market Maker. The market maker is there to provide liquidity, that is the ability to buy and sell ETF's at a fair price whenever you want. Because of the structure of ETF's (Creation and Redemption - read about it here) market makers are able to do this at a reasonably small cost most of the time, that cost is the buy/sell spread. It is simply the difference between the price at which the market maker is willing to buy the ETF and the price at which they are willing to sell the same ETF. For instance lets assume you want to but the A200 ETF, the average buy/sell spread is 0.05% so the market for A200 might look like this;
A market maker willing to buy A200 at $109.98 and willing to sell at $110.03. The real NAV (net asset value ) of A200 might be in the middle $110. So if you decide to buy the A200 for $110.03 from the market maker then you are paying a cost of 3 cents, you are paying 3 cents more than the 'real' value of A200, or about half of the buy sell spread. When you go to sell that ETF you will pay the other half.
In the chart above the red areas represent the buy sell spread. Again the buy sell spread of an active ETF is likely to be higher than for a passive or index ETF. The lowest ETF average buy/sell spread is AAA (the cash fund) at 0.02% and the highest is KSM (K2 small caps fund) at 0.98%.
The buy/sell spread can also change when markets are more volatile or when markets are very illiquid. The spread may also change during the day. So it is always better to buy or sell between 10.30am and 3.30pm to avoid paying a higher spread than you need to.
Brokerage fees
In order to buy and sell ETF's you will need the services of a stock broker and they will (in most cases) charge a fee. The fee will be from $0 (lets talk about that in a sec) up to about $30 per trade. If you receive advice the cost is likely to be higher. Zero brokerage or very low fees are increasingly available but it is worth noting that these come with some issues. Generally if you don't get charged for brokerage there is a reason. It may be that your holding is held in a trust structure rather than in your own name. It might also be that the broker gets a benefit from from your business. Vanguard offer free brokerage on their own products to encourage you in.
I prefer to have my investments in my own name. With my own Holder Identification Number (HIN). In most cases if you are getting cheap or free brokerage the ETF's you buy will not be held in your own name. Ask your broker.
So I am a fan of low or zero brokerage but it is worth while trying to understand why the broker is able to offer that and still make money. I have found that very few brokerage businesses are charitable.
Operational and Transaction Costs
It is easy to find out the management expenses charged by a fund but not so easy to find the operational and transaction costs that you may be charged. To find these you will need to dig into the Product Disclosure Statements or the annual reports for each fund. For many funds these costs are low or zero but for some funds they can be very significant indeed. In the chart above these costs are the light blue area.
These costs include transaction and clearing costs for the fund. The fund needs to estimate what these costs will be. Most use previous years to estimate but new funds don't have that experience. Some new funds estimate and some are silent. We try to keep track of these costs but they are estimates only. Generally funds with hedging costs or geared funds have high operational costs.
In the chart above Operational costs are the light blue area.
Performance Fees
Some funds charge a performance fee. Not many thankfully.
Navigate here for a list of the 24 funds that charge performance fees.
Performance fees are complex. Each one is different but in general fund managers charge a performance fee, usually between 10% and 20% of the amount the fund earns over a benchmark or hurdle rate. So for instance a fund may have a hurdle rate which is the CPI (Inflation rate) plus 5%. They might charge 15% when the fund exceeds this rate. So if CPI is 2% the fund returns 18% for the year they will charge 15% x 11% (the amount the fund exceeded 5%+2%) The fund will charge a performance fee of 1.65% . Simple hey?
Either avoid funds with Performance fees or read the PDS!
I am not totally against Performance fees but their are very very few funds that warrant it.
Tax
That brings us to tax. A fact of life. I do not intend to go deep into the taxation of ETF's in this article. It is another complex area.
Generally ETF's are considered a bit more tax efficient than most managed funds. Thats because most are following indices that don't change all that often so the turnover of the fund is lower than an active fund.
There is only one fund still listed on the ASX that is not domiciled in Australia and as a consequence of that it carries with it some tax risks. That ETF is VTS, the Vanguard US shares index. It has the lowest management fees of all ETF's but I would steer clear of it because of the very complex tax position.
Franking credits are a taxpayers best friend and there are lots of ETF's with solid track records of paying franked dividends. If you don't know about Franking you should! here is a lesson.
Capital Gains and losses - the rules are the same for ordinary shares. If you have sold an ETF during the tax year you will need to calculate a capital gain or loss and if you have held for more than 12 months there will be a discount.
Distributions can be complicated because a distribution can have several taxation elements such as franked income but also capital gains or interest income. The income may be Australian or it could be offshore.
The ETF issuer will send you a tax statement which you will need to use at tax time.
So thats it for the costs. Do they sound a lot? Actually the cost of buying and owning ETF's is I think the lowest cost simplest way to build a portfolio, so the costs are not overly high. The one cost that can catch you out is brokerage because it is generally a fixed cost so if you are buying or selling only small amounts that can become expensive. If you have zero brokerage you don't have a problem (there may be other problems as discussed above) but if you pay $20 per transaction brokerage then you really don't want to buy or sell less than $2000 I think.