ETF fees should not be the primary factor in choosing ETFs

EM feesEnlarge Graph

When choosing among ETFs, some investors prefer lower fees and some higher fees. However, without reading the prospectus, or analyzing other factors, choosing an ETF solely based on fees is not a wise approach. With over 2,000 global ETFs in the market, this may be difficult, but it is certainly necessary. Investors usually choose a group of sector ETFs, and then within that universe they compare fees amongst the candidates. In this article, we will discuss why this may not be optimal.

Some investors prefer lower fees since it does not make sense to pay more for an ETF tracking the same sector as the cheaper alternative. However, investors need to keep in mind that two China focused ETF funds may be very different from each other depending on the underlying indices. The SPDR China ETF, GXC’s reference index, for example, tracks over 600 Chinese companies of all sizes, while iShares Greater China ETF, MCHI’s reference index, tracks over 130 mid and large cap Chinese companies. Returns should differ for these two ETFs given the different nature of their underlying holdings: for 2012, GXC returned 21.7% and MCHI returned 23.3%. Despite the 0.02% difference in fees (GXG’s expense ratio was 0.59% vs. MCHI’s 0.61%), GXG’s return was 1.6 percentage points above that of MCHI, or equivalent to 80x the difference in fees!

Other investors believe that higher fees imply the manager has superior skills, but this cannot be further from the truth. The graph above shows the 2012 returns for several emerging markets ETFs plotted versus their expense ratios. It is clear that there is no pattern of higher fees implying higher returns. Also bear in mind that most ETFs are passive, meaning that the manager’s role is to track the underlying index, not attempt to beat it, therefore any returns are the result of market performance, not the manager’s skill. Comparing FXI, which tracks the 25 largest companies listed in Hong Kong against either GXC or MSCI also shows that the most important driver of returns is index composition, not manager performance.

The one scenario where paying lower fees should matter is when two ETFs track the same index. EEM and VWO both tracked the MSCI Emerging Markets Index last year1 and their returns were 19.1% and 19.2%, respectively, though EEM’s expense ratio was 0.67% vs. VWO’s 0.20%. Over time, the 47 basis point difference in these two fees could compound, and VWO would outperform. In conclusion, ETF fees should not be the sole or main driver of purchasing decisions, except for isolated cases where two ETFs track the same index. Investors need to focus on choosing the right sector and underlying index at the right time, instead of wasting time on expense differences in the hundredths of percentages.

  1. Starting 2013, VWO is gradually switching to the FTSE Emerging Index