What Is An ETF Expense Ratio?

The Juice is all for keeping it sophisticatedly simple for long-term investors. 

There’s no better area to drive this message home than in the ETF space. 

As we discussed in what is really a must-read installment on ETF investing — Monday’s What Is Passive Vs Active Investing — the general space and, especially, active ETFs are booming. However, many ETFs, especially active ETFs, come at a relatively high cost: 

This is why active ETFs tend to be expensive with an industry-average expense ratio of 0.68%. Granted, that’s down from 1.08% in 1996, but still high.

This being — paying for the services of a fund manager who has to do more than mirror a broad stock market index, not to mention the marketing required to lure investors into your fund. 

In that installment, we give you an idea of what’s low and high for an expense ratio. We also define the term: 

When you see “cost” associated with an ETF, we’re mainly talking about expense ratio, which is simply the yearly management cost a fund incurs. At an expense ratio of 0.06%, you’ll pay $6 in fees per $10,000 invested.

Doesn’t sound like a lot, but it adds up, especially on larger investment balances. 

Let’s say you have $100,000 invested in the SPDR S&P 500 ETF (SPY), which has a low expense ratio of 0.09%. You’ll pay $90 in year one on that balance. But it’s not just a $90 annual fee. It’s based on your balance. So, as your investment grows, you pay more each year. A 0.09% expense ratio on a $120,000 balance equals $108.

We think this is a more than reasonable price to pay to be in SPY. It truly gives you access to companies that drive the U.S. economy. If you want a quick summary of what’s inside SPY, follow the link in a couple of sentences. 

For comparison sake, here’s the funny (and a not-so-funny) thing. 

Vanguard has an ETF called the Vanguard S&P 500 ETF (VOO). Take away all of those crazy ass leveraged ETFs and it’s actually the fifth most searched ETF among financial advisors in Trackstar, our proprietary sentiment indicator. Like many Vanguard funds, VOO has a super low expense ratio — just 0.03%. 

The funny thing is SPY and VOO have virtually identical holdings — in name and by composition. Why? Because they both track the S&P 500 Index. So, while you’re not an idiot for being in SPY, the case can be made that if you want to mimic the returns of the S&P 500, you might as well just be in VOO. SPY and VOO generate basically identical returns. With VOO, you’ll pay just $30 on a $100,000 balance and just $36 on a $120,000 balance. 

The not-so-funny thing — there are funds out there that get cute with straightforward indexes, charge relatively high expense ratios and don’t perform as well. 

For example …

The Invesco S&P 500 Quality ETF (SPHQ). SPHQ doesn’t passively invest in the entire S&P 500. Instead it passively tracks the S&P 500 High Quality Rankings Index, which filters the S&P 500 down to the stocks with “the highest quality score, which is calculated based on three fundamental measures, return on equity, accruals ratio and financial leverage ratio.” 

So it’s not even an actively-managed ETF. Yet, it comes with a comparatively high expense ratio of 0.19%. The fund waives 0.04% of that, bringing it to 0.15%. 

On a $120,000 balance, you’re paying $180 annually at a 0.15% expense ratio. That’s $144 higher than VOO and $72 more than SPY. 

• Over the last month, VOO and SPY have outperformed SPHQ by roughly two percentage points. 
• Over the last six months, year and year-to-date periods, the three ETFS have produced pretty much identical returns. 
• Over the last five years, SPHQ beat VOO and SPY by roughly 6%. 

Is that 6% that you could hardly predict worth the higher fees? That’s a question you can only answer for yourself. You can use this little chart we put together to make a comparison. 

We ran those numbers in a straight line, without factoring in dividends or anything, just for illustration purposes. And, clearly, even after factoring in fees, SPHQ, over the last five years, did meaningfully better than VOO and SPY. 

However, here again, we’re looking in the rearview mirror, which is so easy to do in investing. Of the literally hundreds of ETFs out there trying to take market share away from VOO and SPY, who’s to say you’re going to pick the SPHQ of the bunch? And is the risk of paying a relatively high expense ratio and not beating VOO and SPY worth it? 

We think not. 

Because, for every investor, who got lucky and picked SPHQ, we reckon there’s at least one who got sucked in by — just for example — the Pacer Trendpilot US Large Cap ETF (PTLC). And it wouldn’t be too hard to get sucked in by an ETF that sounds like it’s doing so much more than the other guys. 

PTLC adjusts its exposure to the S&P 500 — from between 100% to 0% — based on the index’s technical performance. When the S&P 500 doesn’t look great from a technical standpoint, PTLC invests more of its capital in treasury bills. 

Sometimes more isn’t better; it’s just more. 

Let’s add PTLC and its whopping 0.60% expense ratio to our chart: 

Nuff said. 

The Bottom Line: We’re not picking on Pacer. They just happened to be the unlucky one we pulled from our ETF screen. (By the way, see the Freshly Squeezed section below for a link to The Juice’s favorite ETF screener). But that’s the point. 

When you start screening for ETFs, you’re going to come up with a whole host of names. At the end of the day, it’s a relative rounding error between VOO and SPY for certain and even between VOO, SPY and SPHQ. However, it’s meaningful money in terms of poor comparative returns and high expense ratios between low-cost ETFs and high-cost ones that get too fancy for their own good.

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