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Beyond the Expense Ratio – Is expense ratio the best measure of cost and value?

By: Frank Armstrong

By: Frank Armstrong, CFP, AIFA

Capitalism is a great thing for investors. In return for supplying their hard earned funds to the world’s markets, and accepting the risks that go along with it, they reap substantial rewards. But, market rewards are finite and investment expenses come off the top before the investor gets his/hers. So, investors are rightly concerned with finding the right combination of products, service and costs that will yield them close to an optimum result.

To construct his portfolio the investor builds a prudent asset allocation plan that meets his unique needs and then sets out to find appropriate funds to populate each asset class.

The evidence that markets are efficient is overwhelming. This goes a long way toward simplifying the problem of product selection. Market baskets of stocks like index funds and Exchange Traded Funds (ETFs) are essentially commodities to an informed investor. Because there is almost no evidence anywhere that managers who attempt to time markets or select individual stocks can actually improve results consistently, investors can easily eliminate a source of both cost and risk by simply doing without their services.

The investor can simply define the market and risk factors that he is willing to bear and buy that market basket of stocks at the lowest possible net cost. It goes without saying that an informed investor will eliminate funds that carry a sales load, 12b-(1) fee, or back end surrender charge. This whittles down his choices to a manageable few ETFs or index funds.

At this point, all other things being equal, the investor might prefer the fund with the lowest net ongoing cost. After all, you might surmise that all S&P 500 funds are essentially equal. But, this is where it gets a little tricky.

It would be nice if expense ratios captured all the information we would like to know about the fund’s costs. But, they don’t. It’s a good place to start, however, the knee jerk selection of a fund with the lowest expense ratio may not always lead to the best choice.

The arrival of ETFs has created competition for the traditional index fund companies. For instance, DFA has significantly lowered their expense ratios in the last few months. This can only be good for their investors.

As you should know, turnover creates transaction costs and potentially market impact costs that are not captured in the expense ratio. They actually are not reported or disclosed anywhere. Turnover creates “hidden” costs which must be imputed. Fortunately, most index funds and ETFs have minimal turnover. One would seriously have to wonder about an index fund that had high turnover relative to its peers.

Reconstitution policy is another thorny problem for investors to unravel. Some indexes are changed from time to time by the organization that creates the index. This causes a lot of turmoil in the market. Companies that are being added to an index are in great demand by the index funds, while companies that are being dropped from the indexes relatively few buyers. Prices react predictably to the supply demand equation. This situation creates a wonderful arbitrage opportunity for speculators. Unfortunately, that opportunity comes almost entirely at the expense of the funds’ shareholders. Market impact stings an index fund that finds itself trading for reasons beyond the control of the fund company. How funds deal with this situation will have a measurable impact on performance.

When reconstitution does occur funds that feel they must slavishly follow the index will bear the worst of it, while funds that allow themselves some latitude in making the adjustment will fare better. Uncovering the fund’s policy as it relates to tracking error vs. performance takes a little digging. In many cases an investor might reasonably opt for an asset class fund rather than the classic index fund approach to avoid this problem entirely. For instance, a fund that invested in US Large Companies might not have to adjust to reconstitution nearly as often as an S&P 500 fund. But, the asset class exposure might be almost identical.

Some asset classes are naturally more prone to turnover than others. For instance, small company funds have to sell companies that grow outside of their criteria. It’s possible that companies “on the cusp” of a hold range could bounce in an out of the buy-sell criteria multiple times in a short period. So, an item as arcane as hold range becomes important in controlling costs for investors.

There are two remaining areas where passive managers can have a positive impact on performance that will not be captured in the expense ratio: Securities lending and trading strategy.

If a fund company lends securities it receives compensation from the borrower. They may or may not decide to share that with the investor. Or, they may share only part of the revenue. Companies that return the revenue to the fund rather than keep it add a non-trivial amount to performance.

Finally, in illiquid markets, a company that is willing to purchase large blocks of stock as a purchaser of last resort can demonstrate an average purchase price below the bid-ask spread. Supplying capital to the market in return for substantial discounts adds a measurable value to investors.

Traditional index fund companies like DFA and Vanguard will correctly argue that their policies, trading practices, and securities lending activities should be recognized as an offset to their higher nominal expense ratios when compared to EFTs. Until a more comprehensive measure of net ongoing expenses is devised, investors and their advisors will have to do their homework and make more sophisticated judgments as to value and costs in product selection.