Discover the deeper importance of low ETF expense ratios
June 16, 2023
June 16, 2023
While tallying the total cost of ownership (TCO) for an ETF may seem as simple as adding its expense ratio and trading cost (i.e., spread), there’s actually more to it than that. This shortcut ignores one critical component: time. The longer the holding period, the more a relatively low ETF expense ratio becomes a deciding variable.
Spread is still important, especially for shorter holding periods. But at what point does expense ratio become more important? Asked another way, when does the holding period go from short-term—where spread matters more—to long-term?
As you’ll see, it’s sooner than you may think.
That’s true whether your clients own an equity ETF such as Vanguard S&P 500 ETF (VOO) or a fixed income ETF such as Vanguard Intermediate-Term Corporate Bond ETF (VCIT).
Here, we’ll include both the entry spread and the exit spread—the costs of a “round trip trade.” That’s because if you’re trading in and out of ETFs, say to equitize cash for a discrete amount of time, you’ll be paying the trading spread both times. So again, we’ll include both trades in our TCO calculation.
We’ll also focus on relatively smaller trades that execute within the quoted spread rather than large ETF trades that can include additional market impact costs. Moreover, we won’t include premiums and discounts, which can vary a lot depending on volatility. Both are subjects for another day.
The table below makes clear that the importance of expense ratio gets flipped completely depending on holding period.
With all these considerations in mind, we’ll start by comparing the total costs of VOO and State Street Global Advisors' SPDR S&P 500 ETF (SPY), the most-traded equity ETF by volume in 2022.1 Both ETFs aim to provide exposure to the stocks listed in the S&P 500 Index and seek to track the index’s performance.
SPY’s expense ratio is 0.0945% (9.45 basis points or bps), or more than three times as much as VOO’s expense ratio of 0.03% (3 basis points). This is the cost for owning the ETF for one year. If you own it less than one year, you only pay a pro-rated expense ratio for the holding period.
But the average of SPY’s round-trip trading spread of 0.39 basis points (bp) is a bit more than twice as narrow as VOO’s round-trip spread of 0.83.2 This, again, is the round-trip cost, the sum of the spread when the ETF is bought and when it’s sold.
At first glance, we can observe two things: There’s a real difference in cost to initiate ownership of these two ETFs, and the magnitude of difference between spread and expense ratio is substantial. That said, integrating the trading costs and the expense ratio means that the break-even calculation—when the cost advantage of VOO’s lower expense ratio starts to kick in—comes in 26 days for a round trip trade, as the chart below shows.
The chart also clearly shows that VOO’s lower expense ratio shines more and more beyond the point of breaking even. That’s what the widening space between the two lines is all about. Beyond day 26 of holding VOO, those cost advantages build and compound over time. In other words, investors can take home increasing amounts holding VOO than they would holding SPY.
Shifting to the realm of fixed income, let’s compare Vanguard’s very liquid and low-cost investment-grade corporate bond ETF, VCIT, and the highest-volume investment-grade credit ETF 3, iShares iBoxx Investment Grade Corporate Bond ETF (LQD).
Unlike VOO and SPY, these ETFs are not designed to provide the same exposure. VCIT only includes intermediate-term bonds between 5-10 years of maturity, and LQD includes bonds all along the corporate bond yield curve with a tilt towards more liquid bonds. Despite these differences, they’re similar in terms of risk with both having intermediate durations.
The breakeven in this comparison is just 13 days for a round-trip trade. That’s because VCIT’s expense ratio is 4 bps, or more than three times less costly than LQD’s expense ratio of 14 bps. This difference offsets LQD’s relatively modest spread advantage—0.90 bp vs VCIT’s 1.24 bps.1
Again, it takes 13 trading days for VCIT’s lower expense ratio to make up for the spread difference in an in-and-out round trip analysis.
As in the VOO vs. SPY comparison, the longer the holding period of VCIT, the more the lower expense ratio will enable your clients to maximize returns by minimizing costs.
To put a finer point on the comparison, as the table below shows, an investor who holds $100,000 worth of VCIT for a year before selling would incur a total cost of ownership of $52.41, while it would cost an investor holding $100,000 of LQD for a year before selling $148.96.
Let’s look now at U.S. Treasury ETFs, comparing iShares 1-3 Year Treasury Bond ETF (SHY) to Vanguard Short Term Treasury ETF (VGSH), which offers exposure to 1-3 year Treasury bonds. The round-trip breakeven here is 17 days. VGSH has an expense ratio of 4 bps while SHY costs 15 bps per year. The trading spread on VGSH is 1.70 bps a bit wider than SHY’s spread of 1.21 bps.1
But as with the previous two comparisons, the lower expense ratio becomes more and more decisive once breakeven is reached, which is to say that the advantages of VGSH’s lower expense ratio pay off increasingly over time. And as the breakevens of each example show, it doesn’t take longer than just several days for the expense ratio advantage starts rewarding investors after just several days.
There have always been big differences between day traders and long-term investors and, as these examples show, a lower expense ratio benefits the long-term investor more than the day-trader.
But there are more practical applications of this analysis for investors and their advisors. Some of these ETFs are used by investors to quickly equitize cash or put cash to work with bonds as a temporary holding until they're ready to rebalance, make another investment, or meet a spending need.
In other words, they only plan to hold the ETF for a few days or a couple months. In this scenario, the ETF you choose really matters.
As an example, it could benefit an investor to closely examine the potential cost savings they could realize by holding VGSH for a liability coming due in 30 days as opposed to more costly Treasury ETFs. Likewise, an advisor aiming to quickly equitize a client’s portfolio contribution could potentially consider VOO to fulfill that function, given its low total cost of ownership advantage past the 26-day mark.
The widening delta of extra returns over time related to a lower expense ratio is something most investors will find extremely valuable. Investing success has a lot to do with staying the course over the long haul. Relatively small differences in expense ratio can make a big difference over time.
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1 Source: Bloomberg, as measured by total trading volume over the 2022 calendar year.
2 Source: Bloomberg, The bid-ask spreads appearing throughout this article are time-weighted averages for each trading day in 2022. That spread reflects volatility of every market open and close, and reflects data from days when the Federal Reserves lifted interest rates, and news of Russia’s February 2022 invasion of Ukraine.
3 Source: Bloomberg, as measured by total ETF volume over calendar year 2022.
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