Cheaper Not Always Better With ETFs

Last week, Vanguard, the second-largest issuer of exchange-traded funds in the United States, reminded investors it takes low fees seriously. Vanguard pared expenses on three of its popular ETFs and related share classes, including equity behemoths such as the Vanguard Total Stock Market ETF (NYSE:VTI) and the Vanguard S&P 500 ETF (NYSE:VOO).

Fee Cuts: Not As Simple As They May Appear

Fee cuts are not new in the ETF business. If anything, it is reasonable to expect the issuers that have scale to continue lowering expenses as the battle for investor assets continues intensifying. However, while low expenses are a selling point for ETFs, cheap does not always mean better.

CFRA expects the variety of lower-cost passive products will further cause investors and advisors to shift money away from actively managed funds, in light of the performance challenges. In the three-year period ended 2016 just 7 percent of active large-cap mutual funds outperformed the S&P 500 index, said CFRA Director ETF & Mutual Fund Research Todd Rosenbluth in a note out Monday.

Low fees do help investors over the long-term, but some low fee ETFs and index funds can lead investors to leaving money on the table. Consider a hypothetical example where one ETF charges 0.1 percent per year and returns 30 percent over five years. A competing ETF, perhaps one using a different index or weighting methodology, charges 0.4 percent per year but returns 50 percent over the same five years.

Clearly, the second choice was better, assuming comparable risk-adjusted returns. To give up that much in total returns to save on fees equates to being penny wise and dollar foolish.

In Practice

Look at the Guggenheim S&P 500 Equal Weight ETF (NYSE:RSP). That ETF's annual fee is 0.4 percent, or 10 times the fee on the aforementioned VOO, but RSP has returned 370.5 percent since the start of the current bull market compared to 148 percent for VOO.

There are other examples where pinching a few pennies on ETF fees does not always benefit investors.

For example, the expense ratio for Vanguard FTSE Developed Markets ETF (NYSE:VEA) fell by two basis points to 0.07 percent. This makes VEA one basis point cheaper than iShares Core MSCI EAFE ETF (NYSE:IEFA), said CFRA. However, IEFA's 11.2 percent year to date gain through April 27 was ahead of VEA's 10.4 percent as performance is driven more holdings than fees. VEA has exposure to Canada (8 percent of assets) not found in IEFA and it has a lower stake in France and Germany.

CFRA has a Market-Weight rating on IEFA and overweight ratings on VEA and VOO.

An ETF To Help Avoid Value Traps