Low Expense Ratios Are Not All They Are Cracked Up to Be…

Investors tend to focus on low expense ratio funds, but sometimes they miss the forest for the trees. A lot of mutual funds and exchanged traded funds (ETF’s) tout their low expense ratios but many trail the slightly more expensive passively managed funds. The reason for this lack of performance can be due to many factors:

1.  A lot of times the mutual funds and ETF’s with the low expense ratios focus on the larger markets around the world. They can keep their expense ratios low because they are buying stocks in the largest companies in the world. These companies typically have the lowest performance over the long haul. While “more expensive to buy”, small company stocks tend to have the best performance over longer time frames. 

2.  Many of the “low cost” funds are index funds. They have problems because their goal is to track the index as perfectly as possible. Index funds must buy all of the stocks in the index in the same proportion as the index. At designated times of the year, stocks move into and out of the index and the index funds must make the same changes at the same times. In other words the fund managers are all buying the stocks coming into the index at high prices and selling the stocks going out of the index at low prices. This is done to avoid tracking error and the additional expenses created, known as, reconstitution costs.  

3.  As a continuation of the second point, index funds suffer from what is known as style drift. Since the stocks in the index are adjusted as infrequently as once per year; the level of exposure to various asset classes changes in undesirable ways. For instance, maybe a number of mid-sized companies do poorly and become small sized companies, but these stocks remain in the index fund that is supposed to hold only mid-sized companies. At this point the investor is not getting the exposure to the desired class of stocks as intended. 

4.  Another problem with “low expense” ratio funds is that they are typically missing two key drivers of performance. First, they lack exposure to small company stocks, which have out performed large company stocks by about 3% per year. Even though they are more expensive to trade (resulting in higher expense ratios) small company stocks have better performance over longer time frames. Second, the same can be said for value stocks. Value stocks have historically out performed growth stocks by about 3-4% per year. Value stocks are also more expensive to trade which results in higher expense ratios. Again, the increase in performance more than offsets the additional expense of including value stocks.  It is critical to examine why funds have the expense ratio that they do. Is it because the fund is made up of small company and value stocks or because the fund company is taking a large cut? 

5.  In some of the more thinly traded markets, ETF’s may have a low expense ratios but may also have a large bid/ask spread. Sometimes this spread can be as high as 0.25% or more.  For example, an ETF might have a ask price of $10 and a bid price of $9.75. Since investors buy at the bid and sell at the ask, there is a significant cost incurred unrelated to the expense ratio.  

6.  The intraday tradability of ETF’s is actually considered a drawback by some. Having the ability to trade throughout the day can result in higher turnover and subsequently higher taxes. In the recent market turmoil, August 2015, some ETF investors took a 30% loss on their ETF’s sales when the market was actually down 5-6%. The reason for this,  they sold at the “market” price and there were not enough buyers and sellers (in other words trading volume) and the bid/ask price was significantly lower than the actual value of the underlying ETFs.

Investors that simply focus on having low expense ratio funds might be missing out on key factors that drive performance, like owning small company and value stocks. This point applies to both domestic and international securities. Those same investors are also typically hurt by style drift, reconstitution costs and large bid/ask spreads. These pitfalls a can be avoided by working with an advisor that is a fiduciary. 

In addition to choosing quality funds with a fair expense ratio, a fiduciary can have an enormous impact on growing and protection a client’s wealth through; retirement planning, education planning, tax planning, real estate planning, estate planning and administration, philanthropy planning, insurance planning, etc. Super low expense ratios and small differences in advisory fees are peanuts when thinking about the lifelong value added (dollars and peace of mind) by a fee-only advisor. Zoom out and look at the big picture! 

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

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