Morningstar urges investors to look beyond TER when weighing ETF costs

The note, entitled Calculating the Total Cost of ETF Ownership, said the total cost of owning an ETF is split between two parts; the holding costs and the transaction costs.

The relative importance of these two depend on the investor's time horizon and the total amount they are investing, it added.

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Ben Johnson (pictured), director of global ETF research at Morningstar, explained: "Holding costs will represent the largest component of the total cost of ownership for long-term investors in an ETF, as they are by definition incurred throughout the holding period.

"Transaction costs will matter more to investors who have shorter time horizons, particularly in cases where they are looking to invest large sums of money."

Holding costs

One key cost measure to look at when holding in an ETF, the report said, is the way a fund looks to replicate its benchmark.

Some ETFs use "sampling" techniques to replicate the returns of the underlying index, especially in less liquid areas of the market such as emerging markets or fixed income, which involves investing in a basket of the largest and most liquid securities of the index.

This move, Johnson said, can minimise the holding costs of the ETF and improve liquidity however, it can lead to tracking difference from the benchmark.

He gave the example of the iShares MSCI Emerging Markets ETF, which prior to 2010 only tracked half of the stocks in the index. This led to the fund trailing its benchmark by almost 10 percentage points (ppt).

"While sampling has some obvious advantages, by virtue of excluding some smaller, less-liquid components of a fund's reference index, it creates another potential source of tracking difference as the fund strays from perfectly mirroring its benchmark," Johnson added.

The report said another holding cost to consider is the index turnover costs which usually come through rebalances or M&A activity.

"The costs involved in realigning the portfolio to reflect these changes may ultimately show up in funds' benchmark-relative performance."

Trading costs

When investing in an ETF, the note said an important aspect to look at is the bid-offer spread as these can vary hugely depending on the fund's liquidity.

Liquid ETFs, such as the $254bn SPDR S&P 500 ETF Trust, listed in the US, has a very small bid-offer spread while municipal-bond ETFs will be much wider.

Another transaction cost to consider, Johnson said, is the impact an investor's trade may have on the market.

Larger trades in less liquid funds can have a greater impact and a big trade has the potential to move a product's share price.

Johnson concluded: "Transaction costs matter far more than holding costs in the total cost maths for very short holding periods.

"The longer one's anticipated holding period, the more holding costs matter."

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