Why The Cheapest ETFs Aren’t Always The Best

by on November 17, 2009 | Updated June 30, 2014

While the differences between traditional actively-managed mutual funds and exchange-traded products include several somewhat complex distinguishing characteristics, most investors focus on the relatively simple issue of expenses when making comparisons. Due to their passive nature, ETFs generally offer much lower expenses than mutual funds that can employ teams of analysts and conduct thorough research in an attempt to beat the market (a goal that has proven elusive).

The Cheapest ETFs Haven't Necessarily Been Embraced By InvestorsIf costs are a determining factor for investors when selecting between an investment in an ETF and a mutual fund, one would expect it to also be given primary consideration when choosing between otherwise similar ETFs. Surprisingly, this isn’t always the case.In fact, quite the opposite seems to be the norm in the ETF industry, as there are several examples of investors clearly favoring more expensive ETFs over otherwise comparable funds. Below is a closer look at four such funds, and their “bargain” competitors.

Silver ETFs

For years, SLV was the only U.S.-listed ETF that offered exposure to silver prices by physically buying and holding the precious metal (DBS and USV utilize futures contracts to do so). Earlier this year, London-based ETF Securities made its initial foray into the U.S. ETF industry by launching its Silver Trust (SIVR), a direct competitor. In order to compete with the much larger SLV, the ETF Securities silver ETF offers an expense ratio of 30 basis points, compared to 50 for SLV. Since its launch in July, SIVR has experienced significant growth, although it is still dwarfed by the nearly $7 billion iShares fund.

Pro Members can get a complete look at price drivers of precious metals and recommended funds in our ETFdb Category Report (if you’re not a Pro member yet, sign up for a free trial or read more here).

Ticker ETF Index Assets* Exp. Ratio
SIVR ETFS Silver Trust Spot Silver $390 million 0.30%
SLV iShares Silver Trust Spot Silver $6.8 billion 0.50%
*Based on NSX October data

Emerging Markets ETFs

As investors have regained their appetite for risk following the 2008 recession, one of the most popular investment choices has been emerging markets equities. When investors think of emerging markets ETFs, they generally think of the iShares MSCI Emerging Markets Index Fund (EEM), by far the largest and most liquid ETF in the category. But the Vanguard Emerging Markets ETF (VWO) tracks the same index as EEM (MSCI Emerging Markets Index) with significantly lower fees (0.15% vs. 0.67%).

Unlike the silver ETFs highlighted above (which both hold silver bars), the holdings of these two emerging markets are far from identical, despite the fact that they track an identical benchmark. Of the 823 components of the MSCI Emerging Markets Index, EEM holds 867, which is more than the index itself. The Vanguard ETF actually holds close to 960 individual stocks, about 100 more than are in the underlying index (for a closer look, IndexUnivese has a great piece highlighting the differences between these funds). This difference in composition has had a material impact on returns in 2014: through June VWO had gained about 4.6% compared to 4.0% for EEM.

Ticker ETF Index Assets* Exp. Ratio
VWO Vanguard Emerging Markets ETF MSCI Emerging Markets Index $46.5 billion 0.15%
EEM iShares MSCI Emerging Markets Index Fund MSCI Emerging Markets Index $39.0 billion 0.67%
*Based on NSX June 2014 data

Diversified Commodity ETNs

The rise of the ETF industry has brought commodity investing within reach for countless investors to whom the asset class was previously difficult to access. The iPath DJ-UBS Commodity Index Total Return ETN has been one of the most popular ways to gain diversified commodity exposure, accumulating almost $2 billion in assets. As well, UBS has launched the E-TRACS DJ-UBS Commodity Index Total Return (DJCI), a product tracking the same index as DJP but with two-thirds of the expense ratio. As of 2014, DJCI has $136.2m assets under management.

For a look at how both of these ETNs stack up next to other alternatives for commodity exposure, see this guide to commodity ETFs.

Ticker ETF Index Assets* Exp. Ratio
DJCI E-TRACS DJ-UBS Commodity Index Total Return DJ-UBS Commodity Index Total Return $136 million 0.50%
DJP iPath DJ-UBS Commodity Index Total Return ETN DJ-UBS Commodity Index Total Return $1.7 billion 0.75%
*Based on NSX June 2014 data

Aggregate Bond Market ETFs

The aggregate bond market space is one of the most competitive corners of the ETF industry, with each of the “big three” offering products tracking the Barclays Capital U.S. Aggregate Bond Index. 

Similar to emerging markets equities, there are significant differences in the underlying holdings of these ETFs. The Barclays Capital U.S. Aggregate Bond Index is composed of more than 8,700 individual securities, making exact replication impractical and expensive. So all three of these funds use sampling techniques in an attempt to match duration, yield, coupons, and other key metrics. AGG does this by holding about 2300 individual bonds, while LAG holds about 1400. BND goes much further in its attempts to replicate the index, holdings about 15,000 individual bonds, which is more than the index itself (see this piece by Dave Nadig on the issues facing bond indexes for some insights into these products).

Ticker ETF Index Assets* Exp. Ratio
LAG SPDR Barclays Capital Aggregate Bond ETF Barclays Capital U.S. Aggregate Bond Index $732 million 0.16%
BND Vanguard Total Bond Market ETF Barclays Capital U.S. Aggregate Bond Index $20 billion 0.08%
AGG iShares Barclays Aggregate Bond Fund Barclays Capital U.S. Aggregate Bond Index $17.4 billion 0.08%
*Based on NSX June 2014 data

Cost Cutting Ahead?

The fact that cheaper ETF options aren’t always the most popular is an interesting observation, but the real question relates to what impact this could have on the ETF industry. If the “cheap” alternatives to some of the more popular ETF options gain traction with investors, we may see reductions to expense ratios from some of the major issuers to curtail outflows from their funds.

Disclosure: Long  BND, VWO.