It's time we stop giving ETFs a free pass as the cheapest of cheap investments.
Many, many exchange-traded funds are just that. The cost of owning them is so low it borders on nothing. But a growing number of funds are expensive on two fronts – their management expense ratios (MERs) are comparatively high, and so are their trading expense ratios (TERs). Only when you add these two together do you know the true cost of owning an ETF.
The MER is the definitive measure of the cost of owning a fund, with the notable exception of the trading commissions used to maintain the portfolio of stocks or bonds. TERs are not a factor of any note with the core index-tracking funds that are the most appealing products on the ETF shelf. For example, an ETF tracking the S&P/TSX composite index or S&P 500 index should have a TER so inconsequential that it's expressed as zero.
Both MERs and TERs become more of a factor with new generations of ETFs that either use a rules-based approach that involves screening for stocks based on preset criteria, or employ active managers to pick stocks. MERs for these funds can get into the 0.5-per-cent to 0.8-per-cent range, which is still much cheaper than a mutual fund. Costs can become more of an issue when TERs are considered.
For example, consider the RBC Quant European Dividend Leaders ETF (RPD), a $100-million fund with an MER of 0.56 per cent and a TER of 0.58 per cent. The total expense ratio here is 1.14 per cent, which is quite high for ETFs. The $42-million First Asset Morningstar International Momentum Index ETF CAD-Hedged (ZXM) has an MER of 0.69 per cent, a TER of 0.96 per cent and a total expense ratio of 1.65 per cent.
TERs are shown on an annual basis and a high number for any one year can be an anomaly. Check this by looking at a fund's most recent annual or semi-annual management report of fund performance (links are available on all ETF firms' online fund profiles), or by using the fund-screening tools on the ETF Insight website. You may find a fund with returns that justify high TERs and MERs, but remember one thing: Razor-thin costs are the single most important advantage of ETFs for the individual investor. Don't easily give up that benefit.