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Once investors have narrowed down the universe of 900+ exchange-traded products to those that could potentially match the risk/return profile they’re seeking, the real work begins. When comparing ETFs to find the best fit for a portfolio, one of the metrics most frequently analyzed is the fee structure. While differences in expense ratios may not have a material impact on short-term trades, the long-term impact of compounding costs for buy-and-holders can be significant (see other metrics to consider when comparing ETFs).

In most cases, comparison of fees is a relatively straightforward process; the expense ratio for each ETF is readily available from the issuer Web site. But occasionally ETFs will display multiple expense ratios or something called “acquired fees & expenses” (the adjacent image is from the home page for the iShares S&P Aggressive Allocation Fund (NYSEARCA:AOA)).

So what do all these numbers mean? And which is relevant figure?

The complexity stems from the underlying holdings of certain ETFs. Most exchange-traded products invest in stocks, bonds, or futures contracts. But the holdings of some ETFs consist of other ETFs. So these “fund of funds” or “ETF of ETFs” effectively have a double layer of expenses, since each of the underlying holdings also charges a management fee. This issue doesn’t come up for most ETFs because the holdings–frequently stocks or bonds–don’t charge an expense ratio.

In the case of AOA, acquired fees and expenses comes to about 23 basis points, calculated by multiplying the expense ratio and portfolio weighting of each component ETF:

AOA’s Acquired Fees

Ticker Expense Ratio Weighting Acquired Fees
IVV 0.09% 29.7% 0.03%
IJH 0.20% 22.9% 0.04%
EFA 0.34% 21.2% 0.07%
EEM 0.72% 10.8% 0.08%
IJR 0.20% 7.4% 0.01%
AGG 0.24% 4.6% 0.01%
TIP 0.20% 3.3% 0.01%
Total 0.23%

So in addition to the 25 basis points investors are paying to the manager, the manager is paying another 0.23% to the managers of the underlying ETFs. In this case, iShares waives a portion of the fees (0.14% to be exact), a fairly common practice for many ETF issuers to make the bottom line expense ratio more attractive. That results in a net expense ratio of 0.34%, which represents the effective fees an investor in AOA would pay on an annual basis.

Keep A Watchful Eye

In the above example, acquired fees nearly doubled the effective expense ratio (prior to the offsets from waived fees). While the bottom line number for AOA is still dirt cheap–especially considering that this ETF is effectively a “one stop shop” portfolio–the impact on other ETFs can be more significant. Many of the ETFs found in the Diversified Portfolio and Target Retirement Date categories are structured as ETFs of ETFs, and as such will often incur the double layer of expenses. Some actively-managed ETFs (such as DENT) and hedge fund replication ETFs (such as QAI and MCRO) will also charge acquired fees and expenses.

Acquired fees and expenses won’t pop up only in ETFs whose holdings consist of other ETFs. The PowerShares CEF Income Composite Portfolio (NYSEARCA:PCEF) invests in closed end funds (CEFs), and as such is structures as a “fund of funds.” Because CEFs tend to charge much higher expense ratios than ETFs, the impact on fees in this case is significant; PCEF charges a reasonable 0.50% expense ratio, but the addition of acquired fees and expenses brings the effective cost up to 1.81%.

The Bottom Line

When comparing expense ratios between ETFs, don’t write off acquired expenses to only focus on management fees. The relevant expense ratio is found at the bottom line, after the inclusion of any acquired fees and expenses and the reduction from any waived fees.

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships. Read the full disclaimer here.

Source: Advanced ETF Investing: Understanding Acquired Fund Fees