The expense ratio is the sticker price of an ETF, but there’s more costs than meet the eye when trading. Vanguard recently published an analysis of the importance of low expense ratios within the context of an ETF’s total cost. VettaFi contributor Dan Mika spoke with Bill Coleman, head of U.S. ETF Capital Markets at Vanguard, for a deeper look at where additional trading fees can come up to bite advisors and clients over time.
The following interview has been edited for clarity and brevity.
Dan Mika, VettaFi: What is Vanguard’s preferred way to calculate the round-trip spread costs and why? Why does that make sense for advisors?
Bill Coleman, Vanguard: I think the article really highlights the importance of looking at more than just expense ratios when looking at an ETF. Traditional mutual fund managers and traditional mutual fund investors are used to looking at expense ratios. With ETFs, there’s another cost that investors should be considering, and that is the spreads that they will pay when they buy or sell an ETF. When we look at the total cost of owning an ETF, we’re looking at not only the expense ratio, which you pay over a year. We’re also looking at the spread that you pay when you buy and the spreads that you pay when you sell… We calculate that as if you were going to hold an ETF for just one year. You’d buy it at the beginning of the year, pay the spread, you pay the expense ratio over the whole year. Then you sell it at the end of the year. That’s our round-trip costs.
Best Trading Times
VettaFi: The article uses time-weighted averages for each trading day over the course of a year. What is your advice to advisors who will look at that and say volatility has been elevated since 2020? Is there a way to approach spread costs with more granularity? Or is this the longer-term approach that Vanguard tends to use?
Coleman: I would like to anchor back on the longer-term approach that Vanguard takes with any investments. We encourage everyone to be thoughtful long-term investors. When it comes to spreads and spread volatility, a lot of times when we meet with clients and investors, we educate them on the best times to trade.
One of the things we know is that spreads are typically wider in the first half hour of the day. And then spreads usually widen around 2:00 PM, when the Fed is announcing anything with rates. So we say the best time to trade is to stay away from those events. Stay away from the first half hour of the trading day where spreads are wider, where all the underlying securities are opening up. The spreads usually tighten up by 10:00 AM. They stay pretty tight over the entire day, except for those days where there’s a major economic announcement, particularly the Fed. But other than that, if you look at the spreads outside of those time periods, [they are] very tight. That’s when we encourage ETF investors to really think about executing trades.
Understanding Liquidity
VettaFi: What role does liquidity play when it comes to executing large block trades? How does liquidity factor into how advisors should think when they’re executing these trades? How does it affect what the spread is going to look like?
Coleman: For the average ETF investor, they’re going to be liquid across the Vanguard lineup. But if you’re talking about an advisor who may aggregate trades into a large block, then one thing we’d like to note is, what you see [listed trading volume for an ETF] is really just the tip of the iceberg. There’s a lot more liquidity beneath the surface. If you have a very large block to trade, we recommend advisors utilize their block desk to put it out for quote to get a few different market makers in competition.
A lot of times, those market makers will quote a very tight market for them, whether it’s within the spread… or not too far outside of that spread. That’s something that we monitor a lot, is where our ETFs trade throughout the day. A lot of times, we do have advisors or those who run model portfolios [ask us] how best to trade large blocks. We tell them, “Utilize your block desk, put it out for quote, and you should be happy with the quote that you receive.”
Premium-Discount Volatility Matters
VettaFi: Is there anything else that you think advisors should watch for beyond the expense ratio and the round-trip spread cost?
Coleman: I’d say expense ratio is a number-one driver of cost, and that spread that you pay round trip when you buy them is also a major contributor. Another contributor cost that is less significant than the other two would be premium-discount volatility. That looks at where the ETF is trading relative to its intraday NAV. But it’s important to know that premium-discount volatility is the important factor there, not the premium and discount. So, say an ETF was trading at a constant premium. If you bought at a premium and sold at a premium, you’re not at a loss. Or if you bought it at a discount, you sold it at a discount, there’s no loss. But if there’s a lot of volatility when you buy at a premium and sell at a discount, that can be seen as a cost.
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