Vince Lombardi, the legendary Green Bay Packers head coach, famously declared: “Winning isn’t everything; it’s the only thing.” The statement cemented his public image and became a sports mantra.
Yet Lombardi later expressed regret for the broadness of his statement. “I meant the effort. I meant having a goal,” he later said. “I sure didn’t mean for people to crush human values and morality.”*
In an investing context, low cost has become a mantra. But like Lombardi lamented, it’s become too broad, too much of the focus. Let me explain.
Low cost is good for investors, who get to keep more of their gains. Vanguard has been a driving force for lower fees throughout its history, and it will continue to be. Experts call it The Vanguard Effect® and say it has influenced the entire industry. Costs are falling across the board even as assets are migrating to lower-cost funds—a winning outcome for investors.
How much of a difference can low cost make? It depends.
As expense ratios drop to near zero, there is less relative benefit to choosing the cheapest option in a given category.
Let’s say you invest $10,000 in ETFs. If 10 basis points were your average cost, you’d spend $10 on fund management. If the expense ratios in your portfolio dropped to 9 basis points, on average, you’d save only $1. That certainly raises the question of how important that last basis point is when considering an index fund or ETF.
Cost matters when you’re considering an 80- to 120-basis-point expense ratio investment versus a 12- to 25-basis-point investment. In that case, the expense ratio should be at the top of your due diligence checklist. When the difference in expense ratios among competing products is only a few basis points, cost falls down the checklist.
Let’s consider another famous sports quote:
“Talent wins games, but teamwork and intelligence win championships.” –Michael Jordan
As Jordan suggests, a team needs more than talent to succeed. (Just as additional factors like strategy and portfolio manager execution, when combined with low costs, affect an ETF’s ability to deliver long-term results.)
Five points for your checklist
In addition to considering cost, here are 5 other things to do before you choose an ETF.
1. Look under the hood. The notion that index funds, even within the same category, are interchangeable simply isn’t true. An ETF’s build and management can impact its performance. You only need to look at differences among seemingly identical products, such as emerging markets equity ETFs that have the lowest expense ratios. (See table below.)
A comparison of Vanguard FTSE Emerging Markets ETF (VWO) with the other two funds shows a greater diversification of holdings, differences in the makeup and percentage representation of the top three countries, and a smaller average market cap. These differences can significantly affect the returns for each ETF, underscoring the importance of looking under the hood before making a purchase.
2. Keep a lid on transaction costs. Transaction costs can represent a significant portion of the “all-in cost” of owning an ETF. There are at least two others to consider—commissions and bid-ask spreads. Commissions are trading fees charged when you buy or sell an ETF, and they can add up quickly. Some brokerage firms offer a low flat fee, while others offer commission-free trading for select ETFs. (You can trade Vanguard ETFs® commission-free if you have a Vanguard Brokerage Account.**)
A bid-ask spread is the difference between the price a buyer is willing to pay for an ETF and the seller’s asking price. Even though you incur the trading cost indirectly, the cost is real and unavoidable, and it can be even greater than an ETF’s expense ratio.
3. Pay attention to tracking differences. Index funds are designed to mirror a given benchmark’s return—tracking error measures a fund’s deviation from that benchmark. “Mistracking” a benchmark can easily overwhelm a 1-basis-point expense ratio advantage. This may occur, for instance, if the fund manager fails to match sector exposure, a key characteristic of the fund’s benchmark. For more information on tracking errors, read this blog.
4. Be tax-efficient. Taxes can take a much bigger bite out of your returns than fund expense ratios. You should consider the frequency and magnitude of the capital gains distributed by an ETF. Some equity ETFs can issue large capital gains. Tax-deferred accounts are the best places to keep bond ETFs and funds, but municipal bond funds and ETFs can be a tax-efficient alternative for taxable accounts.
5. Buy from a trusted firm. Consider the brand. Humans, not computers, run ETFs. Investment companies must construct, maintain, and trade an ETF with quality and care. The ethos of an organization bleeds through in the details.
Low cost isn’t everything
In a recent survey by Cerulli Associates, an asset management research firm, the most important factor when considering an ETF is expense ratio.
I agree. However, you can’t overlook a minute expense ratio difference when you evaluate an ETF’s exposure and diversification—the part of the market an ETF covers. To paraphrase and rephrase: Low cost isn’t everything; it’s one factor among many other important factors.
You’d love Michael Jordan on your basketball team, just as you’d love a fund or ETF with a low expense ratio in your portfolio. But overlooking other elements when selecting an investment may be an impediment to reaching a championship, or your long-term goals.
Adapted from ETF Perspectives: Vanguard insights for financial advisors™ (Summer 2017):10–12.
*Sally Jenkins, 2010. Vince Lombardi: The coach that still matters 40 years after his death. Washingtonpost.com. Accessed June 14, 2017.
**Trading limits, fund expenses, and minimum investments may apply.
- Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
- All investing is subject to risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss.