Fees, Valuation and Performance: Understanding Exchange-Traded Funds

The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.

For investment committee members it is important as fiduciaries to have an understanding of not only why the investment portfolio is structured the way it is, but also how it is structured.

Building a well-diversified portfolio can be done in a number of ways. One common approach is to use pooled-investment vehicles to gain exposure to a number of unique asset classes. Pooled-investment vehicles include mutual funds and exchange-traded funds. Both mutual funds and ETFs can be actively or passively managed. An active strategy is driven by a manager or management team selecting stocks in an effort to beat a benchmark index, while a passive strategy is a portfolio constructed to track a predetermined index.

There are fundamental differences to these vehicles, and it is the obligation of the investment committee to understand and determine the best choice for the portfolio in each asset class. It is necessary to understand how fees and fund valuation affect performance when choosing ETFs and mutual funds.

Examine the fees
One of the differences between mutual funds and ETFs are the fees associated with each vehicle. The majority of ETFs use passive strategies, allowing for a much lower expense ratio, the amount it costs to manage the fund divided by the average dollar amount of the funds assets, to be charged for each investment vehicle. This reduction in fund fees is consistent across asset classes commonly seen in institutional investment portfolios. According to Morningstar data, the average difference between ETF expense ratios and mutual-fund expense ratios is 67 basis points (0.67 percent). The analysis includes both actively and passively managed mutual funds and ETFs. This number takes the average savings for the following asset classes: all domestic stock, all international stock, all taxable bond and all commodities. (See Table A for a breakdown by asset class.)

Table A


When structuring a well-diversified portfolio an understanding of how fund fees impact performance will go a long way toward selecting appropriate managers and vehicles. A simple way for investment committees to think about the impact on the investment portfolio is to focus on a single asset class, such as domestic stock. If the domestic stock allocation is made up of mutual funds with average expenses, the funds selected for the portfolio must outperform the benchmark by 1.29 percent before the return on the investment equals the return of the benchmark. It should be noted that these fees are charged to administer the portfolio whether a positive return is realized by the management team or not. To fully understand the impact on the investment portfolio in dollars, we recommend that investment committees request a fee study of the total investment portfolio, including all pooled-investment vehicles, at least once each year. This analysis should include custody fees, management fees, ETF or mutual fund expense ratios and 12b-1 fees.

NAV versus valuation
When analyzing the difference between mutual funds and ETFs it is important to understand how the vehicles are valued and traded. The value of a mutual fund is based on its net asset value. A mutual fund calculates its NAV by adding up the current value of all the stocks, bonds and other securities, including cash, in its portfolio, then subtracting operating expenses and dividing that figure by the fund's total number of shares. The valuation is done at the close of each trading day. The transaction price for mutual-fund investors is based on the NAV. Even though an order for a mutual fund may be placed in the morning, the purchase price will not be determined until the end of that trading day. The net-asset value for an ETF is calculated the same way, but not just at the end of the trading day. Like stocks, and unlike mutual funds, ETFs trade throughout the day on an exchange. This means that investors don’t need to wait to the end of the trading day to discover the purchase price of the ETF transaction.

Supply and demand can also impact the value of an ETF. The NAV of a mutual fund is calculated at the end of each trading day. The mutual fund company satisfies any increased demand by issuing new shares; therefore, keeping the value of the shares at NAV. This is the definition of an open-end fund. ETFs, on the other hand, are not open-end funds. Unless the ETF-sponsor issues new shares to be traded on the exchange, the number of shares of an ETF is fixed. Any excess demand will therefore drive up the price of the ETF over and above the NAV. This is defined as the premium to NAV. As you would expect, discounts to NAV also exist, where supply exceeds demand and the price of the ETF is actually lower than the NAV. These price differences can happen throughout the trading day. The benchmark index performance may approximate the NAV. For ETFs, price differences as a result of supply and demand may cause performance of the ETF to differ from that of the underlying index. Such short-term price swings may also lead to increased portfolio volatility.

Driving performance
There are three components that will drive performance differences between an ETF and the underlying index: fees, strategy and the market price. Fees are disclosed and through a relatively simple analysis we can solve for the strategy and market impact on performance. (See Table B.)

Table B



Most ETFs use a basket of securities to get representative holdings of the index; this is commonly referred to as sampling. To solve for a sampling strategy utilized by the ETF manager we need to add the fees charged to the performance of the index, next we take the difference between the index net of ETF fees and the NAV performance of the fund. In Table C, the strategy row is highlighted to display how it is incorporated into the NAV return number.

Table C


When we solve for the market, we are determining the supply and demand impact on the price of the ETF, if this were a mutual fund we would stop at the strategy analysis as they are priced daily at NAV. The price performance and NAV are readily available numbers and their difference will explain the market impact on the fund’s return. It is important to know the source of the price-return number because this is what is reflected in performance reporting.

In Table D, the short-term supply and demand (represented by the highlighted market row) cause significant discrepancies in the price return compared to the NAV return, but over 5 years this number begins to have a smaller impact on the performance of the fund. As investors, we tend to look at discrepancies with heightened awareness, no matter what the time period, but understanding the source of the discrepancy and long-term impact of the fund will allow for a more disciplined approach to portfolio construction.

Table D


While there are many different investment vehicles available to institutional investors, a thorough understanding of these products is the responsibility of the investment committee. When evaluating whether or not ETFs are the right option, considering the fee, valuation and performance components of these vehicles is an essential part of committee due diligence.

Chris Moran is an institutional investment consultant with Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at cmoran@lancasterpollard.com.

This publication has been prepared by Lancaster Pollard Investment Advisory Group. It is for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investment strategy. The information provided is not intended to be a complete analysis of every material fact respecting any strategy and has been presented for educational purposes only. Please contact your investment consultant to discuss your organization’s situation. The information herein has been obtained from sources believed to be accurate and reliable; however, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or for the results obtained from the use of such information. Opinions and data provided in this article are subject to change without notice. Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or that investors will not incur losses. There are risks involved with investing, including possible loss of principal.


More Articles by Lancaster Pollard:

Guard Against Inflation: Preserving the Purchasing Power of Your Assets
Mission Possible: Finding Capital for Standalone Hospitals
2012 U.S. Interest Rate Outlook

Copyright © 2024 Becker's Healthcare. All Rights Reserved. Privacy Policy. Cookie Policy. Linking and Reprinting Policy.

 

Featured Whitepapers

Featured Webinars