The Real Cost of an ETF is Not the Management Fee

If you were to look through your portfolio, would you know what each of your ETFs was costing you?  

Before you point to outlined management fees, perhaps as low as 0.03%, you may not be assessing the actual cost of holding units in your selected ETFs. The management fee is simply the most obvious cost available. 

Just as with any other investment, there’s more involved and other costs to consider. 

The Initial Costs to Invest 

Before you even pay a management fee for your unit holdings, there have been expenses. 

The first one – and a fee often missed in the calculation of costs – is brokerage. It is the amount you have to pay as a transaction cost for purchasing units and is separate from the cost of the actual units.  

Brokerage fees can range.  

Some don’t charge brokerage for ETF purchases under a certain threshold, while others will charge a flat-fee amount up to $10 or a percentage of the total value of the trade. Where there is no brokerage, there may be commissions paid by an issuer to incentivise the platform to offer the ETF with free brokerage and it’s worth understanding whether that means potentially higher management fees to offset that. 

There can also be a cost associated with a trading platform you use for holding your ETFs or other investments – some investors may split this across their investments as part of estimating the costs to hold, while others may treat this as a separate cost. 

Another cost you may find is the buy-sell spread – there can be a difference in the cost to buy the units in the ETF compared to selling the units, which can affect the final costs of owning units. This is also something to watch if you only intend to hold units for a short period of time. 

The Management Fee v the Management Expense Ratio (MER) 

Investors expect to pay the costs of managing their ETFs, which is why low headline management fees are so appealing.  

The rate you should be paying attention to though is the Management Expense Ratio (also referred to as the total cost ratio).  

The costs to manage an ETF include the management of the assets in the fund (trading costs for the underlying holdings), administration and operating costs (think legal, audit, record-keeping), taxes and paying the team to manage the fund which may or may not include additional performance fees.  

By contrast, management fees simply cover paying the team for managing the ETF – and not the other operational costs.  

These days, some issuers head off confusion by advertising the MER if it is low, such as the Betashares Australia 200 ETF (ASX: A200) which advertises costs of 0.04%.  

You are more likely to find this to be the case where the product is a simple index-tracker compared to more complicated active products. 

An example is the WCM Quality Global Growth Fund (ASX: WCMQ) which includes a performance fee subject to a hurdle. It has a management fee of 1.25%, an administration fee of 0.10% and a performance fee of 0.14% based on a hurdle rate. This results in a total cost ratio of 1.49%. 

Other Potential Costs to Consider 

• Capital gains  

The tax implications of your ETF units can create an indirect cost. If an ETF has higher turnover in the underlying holdings, you are more likely to crystallise gains or losses which can trigger capital gains treatment in your tax return. When you sell your unit holdings too, any gains you make on the sale will be subject to capital gains tax rules. 

• Income and tax 

 The income generated by your units can also have implications for tax treatment. Dividends and interest payments are treated as part of your annual income and taxed at your marginal tax rate. If your selected ETF invests in Australian equities that pay franked dividends, you may be able to use the franking credits to offset your marginal tax rate paid on the dividends, or claim a refund if you are a zero-tax investor. 

• Performance costs from tracking the index 

All going well, ETF performance should largely reflect the performance of the index if it is a passive index-tracker, being slightly lower to reflect fees. If the performance is lower in a way that fees can’t explain, that’s something to be concerned about and is a cost to your portfolio. There can be short-term differences, but you should monitor the tracking error which shows how closely your chosen ETF reflects benchmark performance over time. A bigger deviation in a passive ETF means it is not doing its job – matching the index. When it comes to active ETFs, tracking error is a different story – it is showing you how actively the manager is moving. You would want a bigger tracking error in this case accompanied by higher performance than the index because you are not paying for index-tracking but for active selection.  

The Trade-Offs 

Some costs are not explicit and you won’t pay a set amount for them. They are the trade-offs you make when you choose one option over another. 

For example, the decision to invest in an ETF with a guaranteed quarterly distribution may mean a trade-off against potential upside by investing in higher growth assets, or it could mean a slightly higher cost from incorporating currency hedging to avoid currency volatility in returns. It could be a risk trade-off – choosing a more active strategy in the hope of outperformance which comes with higher risk assets compared to a more passive strategy. 

Choosing an ETF in itself is the choice between directly owning an asset compared to broad exposure to multiple assets (or a costly asset you might otherwise not be able to afford, such as commodities).  

It is helpful to factor these trade-offs in to avoid simply selecting the ‘cheapest’ option which may hit your purse in an unexpected way down the track. 

Quantifying the Costs 

When you compare costs for ETFs, take the time to consider the full expenses – the total cost ratio plus trading costs plus applicable taxes so you can see the full picture and what it means for your portfolio. 

When you think of ETFs as low-cost, they certainly can be but it’s not as simple as the headline fee you see. Like the iceberg, there’s more under the surface so make sure to take the time to appreciate the full gamut to avoid fee surprises to your portfolio down the track. 

Funds Mentioned:

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.