Expense Ratios Aren't Everything: Comparing Vanguard's and iShares' Emerging Market ETFs

Includes: EEM, VWO
by: Don Dion

Thanks to stiff competition in the increasingly crowded ETF marketplace, fund sponsors have begun lowering the expense ratios on many of their most popular products.

Most investors understand that expense ratios can make a big difference in the overall performance of a fund, especially over the long term. For example, $25,000 invested in a traditional, actively managed mutual fund that carries an expense ratio of 1.5 percent will grow to $163,000 in 35 years, assuming a 7 percent annual return. That $25,000 will grow to $227,000 over the same time period in an ETF that charges a fee of 50 basis points. That extra 1 percent in expenses ultimately curtails an additional 28 percent in potential gains.

The good news for ETF investors is that fund sponsors have begun chipping away at expense ratios. A relative latecomer to the ETF marketplace, Vanguard has made up for lost time by moving aggressively to position itself as the sponsor to beat on investor costs. The company currently offers 16 funds with annual fees of 15 basis points or less. Its domestic Large-Cap ETF (NYSEARCA:VV) and Total Stock Market ETF (NYSEARCA:VTI) carry rock-bottom expense ratios of just seven basis points.

There is even some indication that the traditional, actively managed mutual fund world is responding to the pricing pressure from ETFs. Fidelity’s family of Spartan funds has expense ratios comparable to Vanguard’s low-fee ETFs.

Investors traditionally pay more for international or targeted sector exposure. While this remains true at Vanguard, the premium is fairly modest. Domestic sector funds charge 12 to 22 basis points in annual expenses, and the priciest international ETF, the Emerging Markets Fund (NYSEARCA:VWO), will set investors back 30 basis points.

Vanguard has almost certainly put pressure on fund giant Barclays, the sponsor of the iShares line of ETFs, to lower its fees. In fact, Vanguard recently changed VWO’s benchmark to the MSCI Emerging Markets Index, the same index that underlies the iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM), a behemoth with nearly $26 billion in assets under management as of late October. The iShares fund, however, charges an annual expense ratio of 0.75 percent. Earlier this year, iShares lowered the annual fees on most of its international ETFs by four to five basis points. Interestingly, the only fund it didn’t make any changes to was EEM.

But iShares may have a good reason for keeping EEM’s fees where they are. As the ETF giant likes to point out, the expense ratio is an important consideration, but it isn’t the only cost investors should consider when choosing between two similar — or in the case of VWO and EEM – virtually identical ETFs. Implicit costs, such as trading and market impact costs and the fund’s tracking error relative to its benchmark, can also significantly undermine the long-term performance of a portfolio. ETF investors who trade frequently should consider these implicit costs of owning a fund as well as annual expense ratios before writing that check.

So how can investors get a bead on the implicit costs of owning an ETF? Keep in mind that there are essentially two types of ETF liquidity. The first is the ease with which investors can buy and sell their shares on the secondary market, and the second is the liquidity provided by the ETF creation and redemption process. Both types of liquidity can have a direct impact on how quickly, and at what price, investors can execute their trades.

Lehman Brothers did a study of how VWO and EEM performed during the volatile trading of February 27, 2007, when fears of intervention by the Chinese government in that country’s soaring stock market triggered a 9 percent sell-off in Shanghai. Markets across the globe reacted to the pullback in China, and the Dow closed that session down more than 400 points. During trading that day, EEM proved to be the more liquid of the two funds, occasionally trading at twice the volume of VWO. EEM also maintained a tighter bid/ask spread (never wider than around three basis points) than did VWO.

The upshot is that expense ratios only tell part of the total cost story. Investors who trade their ETF portfolios frequently may find that lower implicit costs justify a higher annual fee in certain funds.

Some investment professionals think that investor focus on fees is misplaced, particularly when it comes to ETFs. The priciest exchange-traded funds carry expense ratios of around 1 percent, and these are typically niche products and not portfolio mainstays such as the inverse and leveraged line of funds from ProShares, with annual expenses of 0.95 percent.

The most important consideration when choosing an ETF, then, is not costs — either expressed annual fees or the implicit costs of ownership — but whether the fund’s underlying basket of securities is going to be a profitable portfolio addition.