An ETF is a versatile investment product whose cost of investing has fallen sharply over the last decade

It is a truly global investment product and whose AuM (asset under management) crossed $10 trillion during the year 2021. Simplistically, it is a listed MF (mutual fund), which can be traded on stock exchanges like a stock/ share.

ETFs have gained immense popularity over the past ten years and during which their worldwide AuM grew more than 5 times, from $1.7 tn to $10.02 tn. It can contain all types of investments, including stocks, commodities, or bonds. Additionally, it tend to be more cost-effective and more liquid, as compared to the mutual funds. An ETF can be an effective vehicle to diversify one’s portfolio across geographies (globally), asset classes (equity/ bond/ commodities), industries/ sectors, currencies, themes (disruptive technologies, renewable energy, EVs, among others), etc. Moreover, fierce competition among fund issuers has resulted in much lower expense ratios across different fund classes.

Any investor who foresees funds requirement in foreign currency, outside of India in the future, must consider creating a ‘dollar-denominated’ corpus. ETFs are an ideal vehicle to achieve this as they are low cost instruments in which monies can be chipped away regularly (say monthly). The fact that INR is a depreciating currency (has depreciated by 4% annually over a long period of time in the past) helps adding to the overall returns (in the INR terms) and since the anticipated usage in USD, the exchange risk stands mitigated. In fact, the investor gets access to investment themes/ opportunities unavailable in India.

What is the total cost of ownership of an ETF?

There are four direct costs associated with ETFs: expense ratio, commissions, premiums/discounts (to NAV) and taxes. Additionally, there are the indirect costs, tracking error and liquidity constraints (i.e., bid/ ask spread).

Expense Ratio

The expense ratio is the most obvious direct cost associated with ETF investing. It represents the portion of one’s investment that goes towards the fund management fees, which are incurred annually. For this reason, ETFs with lower expense ratios are seen as advantageous.

Brokerage

Brokerage is the fees the investor pays to the broker to buy and sell ETFs (similar to the fees paid to buy and sell stocks). The good news is commissions have declined sharply thanks to competitive forces. This has led to the rise of the commission-free ETF.

Premiums/ Discounts (to NAV)

It sometimes trade at a premium or discount, which can often mean additional costs. For example, if one buys an ETF at a premium and then sells it at a discount, he/ she loses money. In terms of ETF investing, premiums and discounts are understood within the context of the net asset value (NAV), which represents the sum of a fund’s assets minus liabilities, divided by the total number of shares outstanding. If a fund doesn’t trade close to its NAV, there may be issues with its creation/redemption strategy.

Taxes

The total cost of it’s ownership cannot be divorced from the tax implications of investing. ETF portfolios that realize capital gains will be subject to capital gains taxes. ETFs that distribute dividends also have more immediate tax implications whereas non-dividend funds are taxed only when shares are sold.

Tracking Error

A fund’s tracking error is another important consideration for evaluating it’s total cost of ownership. Since passive ETFs are designed to track the performance of their underlying indexes, investors should consider funds with a median tracking difference that is close to the expense ratio. 

Liquidity Constraints

When it comes to buying and selling ETFs, liquidity constraints become apparent in the bid/ ask spread. This is the difference between the price a buyer is willing to pay for shares and the price at which the seller will offload it. Trading volume and liquidity have a direct influence on the bid/ask spread. 

However, for investors (as compared to traders), the indirect costs are less relevant because they intend to hold the asset for a long time. In this case, it doesn’t matter how much the bid/ask spread fluctuates or whether underlying liquidity is low. So investors need to focus on ETFs with a lower expense ratio that trade close to their NAV.

To calculate it’s cost for one year, there are three immediate factors which need to be considered:

• the expense ratio (as a percentage of amount invested)
• the per-year bid/ ask spread percentage
• the per-year commission (on buy and sell transactions)

Conclusion

An ETF ticks all the relevant boxes qualifying as a simple and an effective instrument to deploy monies across geographies, in different asset classes, themes, offering smart trading strategies across clearly defined time horizon. Furthermore the true cost of ownership (of ETFs) has declined sharply with cost-cutting having taken on a heightened level of importance. Collectively, these factors have led to a significant build up in ETF AuMs, across the globe, helping investors achieve their financial goals in a cost effective manner.