Key Takeaways:
- A hypothetical $10 million position shows how a higher-fee fund with tighter spreads can cost less to own.
- Concentrated ownership can leave a large ETF with thin trading and wider spreads when that one holder sits out.
- Limit orders, risk trades and creation orders give advisors more control over execution costs than simple market orders.
The firm, the asset management arm of State Street Corporation (STT), tackled three common misconceptions in a recent guide. These cover total cost, how liquidity is measured and how trades are executed.
State Street’s own data cuts against the first myth. Among the 100 largest U.S. equity ETFs, fees showed no correlation with average bid-ask spreads. With more than 5,000 U.S.-listed ETFs available, that means a fee screen alone can miss what clients pay to trade.
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The Liquidity Cost Hidden Behind Low Fees
Matthew Bartolini, State Street’s global head of research, and colleague Colin Ireland put numbers to the idea. Their hypothetical compared two funds tracking the same index, each with a $10 million position.
Fund ABC charged a 0.07% expense ratio with a 0.05% average spread. Fund XYZ charged more, at 0.10%, but traded at a 0.01% spread.
After a 20% gain, an annual rebalance sold $2 million. XYZ’s total costs came to $12,200, or 0.11% of average assets, versus $13,700, or 0.12%, for ABC, the authors calculated. In that case, ABC saved $3,300 in fees, but its wider spread added $4,800 in trading costs.
Raising the sale to $6 million widened the gap. ABC’s costs climbed to $15,700, or 0.14%, while XYZ’s rose to $12,600 and held at 0.11%, the example shows.
“Buying an ETF based on its headline expense ratio alone may not lead to the most cost-efficient solution,” Bartolini and Ireland wrote.
Their advice is to match the cost focus to the strategy. Long-term, low-turnover holdings put more weight on the expense ratio, while tactical portfolios that rebalance often should focus on trading costs.
Some portfolios fall in between, such as a long-term 60-40 mix rebalanced monthly. For those, they suggested a “liquidity” component that splits assets between the lowest-fee funds and the most liquid ones.
Why One Liquidity Snapshot Can Mislead
The second myth concerns how liquidity gets measured. Many investors rely on 30- or 90-day averages, but a fund’s profile can shift with the market, according to a separate analysis by the pair.
That study, which uses 2018 and 2019 data as a hypothetical illustration, compared two funds focused on the same market. Fund A had a lower expense ratio, at 0.11% versus 0.14%, and the lower total cost on a 30-day lookback. Over 90 days, the two tied at 0.16%.
“Does Fund A have the lower total cost? Maybe. Maybe not. We need to look beyond one data point to find out,” the researchers wrote.
Stretching the review from January 2018 through June 2019 told a different story. Fund B’s spread stayed under 0.03% every day, while Fund A’s topped 0.07% on more than 134 days, or 34% of the time, the data showed.
Then Fund A’s profile shifted in 2019. Its assets grew from more than $1.5 billion to nearly $3 billion, and median daily trades rose 64%, from 1,641 to 2,686. Even with a 0.04% spread during a volatility spike, its total cost of 0.15% stayed below Fund B’s 0.16%, the analysis found.
Size alone doesn’t guarantee liquidity, though. In another State Street comparison, two smart beta ETFs held similar assets of $554 million and $520 million, but one investor owned 90% of the smaller fund.
From January 1 to June 6, 2019, that concentrated fund logged 4,616 trades, compared with 43,271 for its peer. Its median spread was 0.14%, against 0.05% for the fund with a broader investor base, based on Bloomberg figures.
“If that one large client does not trade, volumes are light, and liquidity can dry up,” the authors noted.
Execution Choices Shape the Final Bill
The third myth assumes every ETF trade works the same way. State Street’s trading guide noted that ETFs draw on two layers of liquidity: trading in the fund’s shares and the securities it holds.
Authorized participants, broker-dealers that create and redeem ETF shares, tap that second layer. They swap baskets of securities for blocks of 10,000 to 600,000 fund shares, the guide explained.
Order type matters, too. In one State Street hypothetical, only 1,000 shares sit at the best offer of $36.25. A 20,000-share market order would sweep through four price levels, filling at an average of $36.35, or 10 cents above that offer.
A limit order at $36.25 would fill those first 1,000 shares right away, with the rest waiting at that price. Setting the limit slightly above the best offer can improve the odds of a full fill, the guide suggested.
Larger orders have two other routes through institutional trading desks, according to the firm. A risk trade locks in one immediate price, with the desk taking on the market risk. A creation order instead prices at the closing net asset value, plus underlying trading costs and the sponsor’s creation fee.
That fee is charged per order rather than per creation unit, State Street said. It generally ranges from several hundred to several thousand dollars, depending on the ETF and its asset class.
Previously posted on ETFDb.
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