The rule when buying ETFs is that when all things are equal, buy the one with the lowest expense ratio. But remember that similar sounding ETFs often aren’t equal. This means don’t let the expense ratio be the only factor in choosing an ETF.
“Our belief is expenses and past performance matter, but more important is understanding what’s inside the portfolio,” said Todd Rosenbluth, S&P Capital IQ director of ETF research.
SPDR S&P 500 ETF (SPY) tracks the S&P 500 stock index and charges a tiny expense ratio of 0.09%, commonly called nine basis points. One hundred basis points make up 1 percentage point. Guggenheim S&P 500 Equal Weight ETF (RSP) also tracks the S&P 500. But it charges a fee of 0.4% of assets.
Look At The Performance
“You might ask ‘Who in their right mind would pay 40 basis points vs. 9?'” said Ron Delegge, founder of ETFguide. “But then you take a look at the 10-year return.”
RSP returned an average annual 9.42% in the past 10 years, compared with 7.85% for SPY, according to Morningstar. In fact, RSP beats SPY in all periods reported on Morningstar.com, from one month on.
The big difference between the funds is the way the indexes are weighted. SPY follows the S&P 500’s classic market-capitalization weighting, which multiplies the stock price by the number of shares outstanding to get a stock’s market value. The biggest companies get a larger weighting, comprising a greater percentage of the index than the smaller ones. Thus a $1 move in Apple (AAPL), with a 3.98% weighting, will lift or drag down the index much more than a $1 move in the shares of Diamond Offshore Drilling (DO), which has a weighting of just 0.01%.
But RSP gives every stock in the index an equal weighting of 0.2%. This means a $1 rise in Diamond Offshore’s stock moves the index just as much as a $1 increase in Apple’s shares. By giving greater weight to the smaller stocks in the index, this has a big effect on the fund’s performance. Year to date, RSP is up 2.25% vs. SPY’s 1.29%, 96 basis points more — after paying the expense ratio.
“Would I be willing to pay more for those returns?” asks Delegge. “Definitely.”
Of course, SPY could just as easily outperform RSP in periods when the market favors large-cap stocks or other factors that can be found in SPY but not RSP.
But S&P 500 trackers aren’t alone. “One example that is much maligned is PowerShares FTSE RAFI U.S. 1000 ETF (PRF), said Michael Krause, president of AltaVista Research in New York, which runs the ETF Research Center website. “I calculate that cumulative since its inception in 2006, PRF has outperformed iShares Russell 1000 ETF (IWB) by 14 percentage points.”
ETF Research Center pegs PRF’s average annual return since 2006 at 8.9% vs. 8.1% for IWB.
PRF’s expense ratio is 0.39%, while IWB charges 0.15% of assets.
This trend happens a lot among the industry ETFs. SPDR S&P Homebuilders ETF (XHB) and iShares U.S. Home Construction ETF (ITB) sound like they track the same industry, meaning they should post similar results. XHB charges 0.35%, while ITB charges 0.45%, so XHB seems like a better choice.
Yet only 35% of the XHB holdings are actual homebuilding companies, and 28% building products. The rest of the stocks are home furnishing producers and retailers, home improvement retailers and household appliance makers. However, homebuilding companies make up 71% of the ITB portfolio, with building products at 13%.
ITB has risen by an annual average of 25.72% in the past three years vs. 21.01% for XHB. Year to date, ITB is up 8.32% vs. XHB’s 6.74%. That more than compensates for the extra 10 basis points.
“Cheaper hasn’t been better as of late,” said Rosenbluth.
Originally published in Investor’s Business Daily.