A Closer Look at the Total Cost of ETP Ownership (Part 2)

When looking for the lowest-cost exchange-traded product, it's important to take a holistic approach and mind the bid-ask spread.

Michael Rawson, CFA 30.07.2015
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In part 1 of this article, we looked at how total costs of owning ETPs add up. In Part 2, we will look at some real life examples on some U.S. listed ETPs.

The Case of the S&P 500 ETFs
Differences in trading costs can help explain why one ETP is more popular than another, despite having higher holding costs. The best example of this is SPDR S&P 500 (SPY, listed in the U.S.). The exchange-traded fund tracks the S&P 500 and carries a 0.09% expense ratio. Since the inception of Vanguard S&P 500 ETF (VOO, listed in the U.S.) nearly five years ago, SPY has returned 16.95%, lagging the S&P 500 by 0.26 percentage points. This compares unfavorably with iShares Core S&P 500 (IVV, listed in the U.S.) (0.07% expense ratio) and VOO (0.05%), which returned 17.12% and 17.17%, respectively, during the same period. SPY has higher holding costs in part because of its unit investment trust structure.

Despite SPY's higher holding costs relative to IVV and VOO, SPY claims 63% of the total assets invested among the three funds. Though SPY has been less efficient at tracking its bogy, it trades an astounding US$24 billion a day, making it the most heavily traded security on the planet. The tremendous liquidity results in average bid-ask spreads of just one half of 1 basis point. That's tighter than any other ETP and amounts to just US$4 for a US$100,000 trade. For IVV, the average bid-ask spread over the 30 days through June 19 was 1 basis point, and it was 1.1 basis points for VOO.

For a trader moving a large sum of money over a short period of time, SPY's lower trading costs trump its relatively higher holding costs in tallying the total cost of ownership. However, in recent years, the cost of trading IVV has fallen. While VOO has the highest trading costs among the three funds, it has the lowest holding costs and should be cheaper for long-term investors. The chart below illustrates this pattern. It shows the total cost of ownership based on a US$5 million trade. The calculation is an estimate of the total cost of owning these funds and is composed of both trading costs and holding costs. Because trading costs are only incurred when trading, they will be a larger component of total costs for shorter holding periods. Over longer periods, the holding costs will become more important, as the trading costs will be amortized over a longer period of time. All else equal, the larger the dollar amount of the trade, the larger the trading costs will be. The costs are annualized and expressed as a percentage similar to an expense ratio. So for a one-week holding period, annualizing the cost means that we can assume the ETF is bought and sold every week over the course of one year. A 26-week holding period would imply buying and selling the ETF twice in a year.

The holding period, measured in weeks, is plotted on the horizontal axis. We would expect costs to fall over time since the longer the holding period, the more the trading costs get amortized. For holding periods shorter than a couple of weeks, SPY is the cheapest option. For holding periods between two and 24 weeks, IVV is the cheapest. Beyond that, VOO is the cheapest. As you can see from the exhibit below, VOO is the most expensive over very short holding periods because it has the highest trading costs.

Source: Morningstar.

SPY's lead in liquidity may be slipping. Between the three funds, SPY's 63% share of assets is down from 78% five years ago, as can be seen in the exhibit below. SPY's share of dollar volume has also declined, albeit more slowly. Among SPY, IVV, and VOO, SPY now has 96% of the trading volume compared with 98% five years ago. It takes time for a more efficient ETP to wrest market dominance from a more liquid ETP, but it can happen. Back in 2010, SPDR S&P MidCap 400 (MDY, listed in the U.S.) controlled 56% of the assets and 89% of the dollar trading volume between itself and competitor iShares Core S&P Mid-Cap (IJH, listed in the U.S.). Today, MDY has less assets than IJR and its share of dollar volume has dropped to 83%. Investors need to be aware of both trading costs and holding costs when evaluating ETPs. Long-term investors should place more emphasis on holding costs, while traders should focus on trading costs and keep in mind that the most liquid ETP in a category can change over time, as long-term investors gravitate toward the most efficient ETP.

Source: Morningstar. 

In summary, a fair comparison of the costs of ETP ownership should include an analysis of trading costs such as the bid-ask spread. Both the liquidity of the ETP and that of its underlying holdings influence trading costs. While short-term traders may place a bigger emphasis on trading costs, over longer time horizons, holding costs become a more important factor.

 

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Michael Rawson, CFA  Michael Rawson, CFA is an ETF Analyst with Morningstar.

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