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Hidden Costs of Ultra-Low-Cost ETFs

We are in a race to the bottom in fees in the asset management industry. The largest online discount brokers have all reduced commissions to $0 on stock and ETF trades. This is great news for individual investors. It also strengthens the advantage of ETFs over mutual funds for financial advisors and their clients. ETFs already had the tax advantage of deferring capital gains until sale, compared to paying them annually with a mutual fund. Now ETFs have zero transaction costs, compared to mutual fund trades that can cost from $10 to $50 per transaction, even for no-load, low-cost mutual funds at most online discount brokers.

Once one makes the switch to ETFs, though, it can be tempting to continue to focus just on fees and opt for the absolute lowest cost ETFs out there. All the major ETF brands (Blackrock’s iShares, Vanguard, State Street’s SPDRs, Schwab) now have ultra-low-cost ETFs available with an expense ratio of 0.03%. However, all these funds are concentrated in large cap growth stocks. In fact, three of the top four global ETFs simply track the S&P 500 Index. What happens when investors make the smart decision to buy an ETF, but then just choose the one with the very lowest expense ratio? Funds flow into the market demanding to buy the 500 largest US companies, regardless of price. This price-insensitive demand drives up the prices of the top 500 US large cap (largely) growth stocks. A better approach would be to focus on fees and investment strategy in selecting ETFs.

For just a few more basis points of expense ratio, investors can buy still-very-low-cost ETFs that track better indexes to give them exposure to value stocks, small and mid-cap stocks, international and emerging market stocks, all of which have a higher expected return that US large cap growth stocks in the current market environment. And for just a few more basis points of expense ratio, investors can buy low-cost ETFs that are actively managed to maximize expected return based on rigorous academic research using small cap, value and profitability factors.

As a value investor, I like the "value" proposition of getting a high-expected-return, sophisticated, quantitative investment strategy for the price of a low-cost ETF expense ratio.

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