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There’s More to ETF Costs than Management Fees

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BY: MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS

Why are ETFs so popular? One reason is that they typically provide a lower-cost way to invest in a given asset class, versus the fees charged by comparable, regular mutual funds.

However, understanding investment costs, particularly those associated with ETFs, can be quite confusing. For starters, when discussing investment costs, we’re not necessarily just talking about management fees. Although they are a component of total cost, they certainly do not reflect the full cost of owning an investment.

If you map the growth of ETFs over the last 15 years, you’ll notice there is a strong correlation with a movement towards indexing as an investment strategy. In Canada, for example, roughly $7 out of every $10 in ETFs is invested in passively-managed ETFs that track a publicly available index1.

The rise in indexing stems from the simple fact that most actively managed equity funds fail to generate longer-term returns that exceed the returns of their stated benchmark. The chart below is from the most recent Standard & Poor’s Index vs. Active (SPIVA) scorecard. It shows that over a five-year period, less than 20% of active fund managers beat the S&P/TSX Composite Index, and less than 3% of managers beat U.S. equities.

1Source: Strategic Insight, as at December 2017.

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FOR ILLUSTRATIVE PURPOSES ONLY
Source: Standard & Poor’s, as at December 31, 2017 (Report from April 2018).

Investors who choose to index have a huge statistical tailwind in their favour. For instance, by simply selecting a large-cap Canadian equity index strategy, you historically would have outperformed 80% of the funds available in Canada over the last five years – and if you opt for an S&P 500® Index ETF, you would have outperformed more than 97% of the U.S. large-cap equity offerings.

Typically, after an investor has made a decision to invest in an index strategy, cost likely becomes one of their primary selection criteria. This makes sense, as an index strategy is rarely going to exceed the return of the benchmark, so reducing the investment fund’s cost can be expected to improve performance.

In assessing cost, the first place where most investors look (and often the only place) is the management fee of the ETF. For large-cap Canadian and U.S. index ETFs, for example, management fees tend to range from 0.03% to 0.10% for the more widely followed products.

Costs of Investing

Management Fee
The management fee, as the name implies, is the amount paid to the ETF fund manager. It is expressed as a percentage of the fund's average assets for the year. This fee, however, is only one component of cost.

Management Expense Ratio (MER)
The MER includes the management fee plus the fund's day-to-day operating expenses, such as record-keeping, fund valuation costs, audit and legal fees. The MER also includes sales taxes, where applicable. This expense is detailed on our website within an ETF page’s ‘Regulatory ETF Facts’ document, as well as in our annual and semi-annual Management Reports of Fund Performance (MRFP).

Trading Expense Ratio (TER)
The MER doesn’t include portfolio trading costs, which are identified separately as the TER. This expense, like the MER, can be found on our website within the ‘Regulatory ETF Facts’ document of an ETF or in its annual and semi-annual MRFPs. ETF providers typically don’t showcase this expense in marketing documents because it varies based on a number of factors. Sometimes this fee is small, or sometimes it’s larger than the actual management fee. In any case, it makes sense to take a look at the regulatory documents to get a sense of this and other costs.

Tracking Error
Tracking error is the difference between the returns of an index ETF and the index it tracks. Sometimes, this difference can be small, but sometimes it can be substantial – particularly in less liquid asset classes like fixed income. Factors which impact tracking error are numerous and can usually be attributed to the expense of managing the fund, namely the MER and the TER. Distributions paid by index constituents can also play a role in tracking error as most ETFs do not reinvest distributions but instead pay those distributions to end unitholders, while most indices are automatically reinvesting. This loss of compounding can create tracking error and the treatment of cash distributions can have real tax implications for some investors. Tracking error is a real cost since it showcases the difference in the performance of the ETF vs the benchmark it is seeking to replicate. If an ETF has a large tracking error relative to the index performance, that may suggest that the ETF has potentially significant replication issues.

Bid/Ask Spread
When buying units of an ETF, there are typically costs associated with that purchase in the secondary market (on the stock exchange). Part of this cost can be determined by looking at the difference between the bid price and the ask price being quoted on the ETF, which is known as the bid/ask spread. The wider this bid/ask spread, the more an investor is paying to execute the trade on the ETF – versus the actual net asset value (NAV) of the units being bought or sold.

Bid/ask spreads are tricky, because they are usually a function of the underlying liquidity of the ETF, so on an asset class like large-cap Canadian equities, this spread is usually no more than $0.02 a unit. However, on a less-liquid asset class like foreign equities or foreign fixed income, it could be close to $0.10 a unit. It’s important to compare the bid/ask spread on ETFs that invest in the same types of securities to determine if the cost of the ETF execution is high relative to other ETFs. Bid/ask spread information may also be found in an ETF’s ‘Regulatory ETF Facts’ document.

Another cost of purchase and sale is any commission paid to your broker for the trades.

Taxes
Every investor’s tax situation is different, but taxes are a very real cost. Different ETF structures exist to mitigate the impact of taxes. Take U.S. large-cap equities, for example.

Distributions from foreign-listed securities are taxed in Canada at the full marginal tax rate of a Canadian resident investor (who is not a U.S. person). Canadian residents who receive distributions from foreign sources are subject to various rates of non-resident withholding tax (depending on the country of origin and type of income) ranging from 0 to 35%. For non-U.S. foreign securities, this may apply even if the security is held within a registered account. Canadian investors are subject to withholding tax on U.S. distributions if they hold the securities in a Tax Free Savings Account (TFSA) or a non-registered account.

Where foreign non-resident tax has been withheld from a distribution to a Canadian investor (other than to a registered account), the investor may also be entitled to a foreign tax credit for all or a portion of the foreign tax withheld.

The following hypothetical example highlights the expected after-tax performance benefits of holding the Horizons S&P 500® Index ETF (“HXS”) versus another Canadian-domiciled physically replicated U.S. equity ETF in a non-registered account, assuming both ETFs earned a net 2% dividend and track the exact same universe of stocks (in the same proportions). This example does not take into account any fees or expenses of the ETFs, or any commissions, fees or expenses that would be associated with the purchase or sale of the ETF units. Both ETFs are held by an Ontario resident (non-U.S. person) investor in the fourth-highest tax bracket, who would have had a marginal income tax rate of 46.41% in 2017. The example does not contemplate the sale of the ETF units or any tax liability that would result. It also assumes no change in the market value of the index constituents.
 

    Physically Replicated ETF   HXS
  Principal Investment    $100,000   $100,000
  Market Return (0%)    0%   0%
  Net Dividends of Constituents    $2,000   $2,000
  Pre-Tax Total Portfolio Value    $102,000   $102,000
  Foreign Withholding Tax (15%)*    $300   $0
  Taxes on Dividends (46.41%) **   $928.20   $0
  Total Tax Payable    $1,228.20   $0
  Total After Tax Portfolio Return    $100,771.80   $102,000
  Difference in Return   -$1,228.20   $1,228.20
  Return Lost to Tax on Distributions    -1.23%   0%

Source: Morningstar. Maximum MER of HBAL and HCON is lower than all December 31, 2017, MERs of conventional retail offered Canadian mutual fund classes.

*Where a Canadian ETF holds U.S. securities, non-resident taxes will be withheld from payments that are subject to U.S. withholding taxes (such as most dividends). Depending on the ETF, some or all of the Foreign Tax Credit may be passed on to unitholders. No Foreign Tax Credit is contemplated in this example.
**Based on combined provincial and federal rates, as disclosed for the 2017 tax year. This rate does not contemplate any non-resident withholding tax that may be withheld by the relevant foreign jurisdiction(s) or any resulting foreign tax credits.

At Horizons ETFs, we are committed to creating innovative solutions that strive to meet the needs of all investors. Part of that means structuring our products in a way that contemplates all of the fees and expenses previously mentioned – and providing investors with options that mitigate as many of these costs as possible. Examples of this include our recently launched low-cost1 ETF portfolio ETFs, the Horizons Conservative TRI ETF Portfolio (HCON) and the Horizons Balanced TRI ETF Portfolio (HBAL), which have no direct management fees.  We’re proud to be the first ETF provider in Canada to not charge a direct management fee, but it’s important to note that these ETFs are subject to the fees and expenses of the underlying ETFs they hold, up to a maximum MER of 0.17% for HCON and 0.18% for HBAL. These ETFs are not free, but we believe that when you factor in all of the costs discussed above, these might be the lowest-cost ETF portfolio solutions in Canada.

What is the lowest cost ETF? The answer is not simple. It’s important to look at a range of costs associated with an investment in an ETF and find the index solutions that offer the lowest cost exposure for your portfolio needs.

1 Source: Morningstar. Maximum MER of HBAL and HCON is lower than all December 31, 2017, MERs of conventional retail offered Canadian mutual fund classes.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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