ETFs and Funds Lessons

ADVANCED: Calculating Total Cost of Ownership for an ETF

When reviewing an ETF, most people only look at the basis points (BPS) of the expense ratio. Most of the time things like tracking error and average spread aren’t even a consideration. Unfortunately, like high 401K or mutual fund fees, this can end up eating away at your long term profits. Its not necessary to do this for every ETF you’re looking at, but for ones you are undecided on or are planning to hold for multiple years this can be a deciding factor. The equation below will give you a better idea of how to compare ETF total costs.

Shared from ETF.com

“The most appropriate way we have found to determine a fund’s TCO (Total Cost of Ownership) is to use the following equation:

TCO = C + ½ SC + TE

C = management fees; SC = spread cost; TE = tracking error

Using this equation, it’s clear that an ETF with a higher expense ratio may actually have a lower TCO than an ETF that has a lower expense ratio and a higher NAV tracking error. In a real world example, the ROBO ETF’s NAV has a one-year tracking error of just .18%. Here’s what the TCO equation looks like with real numbers in place:

TCO = C (.95%) + ½ SC (.036) + TE (.184) = 1.17%

Now let’s compare that to a similar ETF with a higher tracking error. In this case, while the cost is slightly lower at .68%, the tracking error is significantly higher, at .75%. Here’s the equation:

TCO = C (.68%) + ½ SC (.0021) + TE (.75) = 1.43%

 

Original Post at ETF.com

Note: nearly every ETF database will list all 3 variables for you.