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TSC Ratings Finds Super-Cost-Efficient ETFs

ETF investors should be aware that ownership of these vehicles involves costs that extend well beyond brokerage commissions when shares are bought and sold.

We screened ETFs in Ratings database and identified three "super-cost-efficient" funds, as well as others that should appeal to the cost-conscious investor.

In addition to the expense ratios levied by the ETF management firms, investor returns are impacted by the bid/asked spreads, as well as by discounts and premiums of market price vs. net asset value per share when shares are bought and sold.

Even minor bloat in these often-overlooked expenses shouldn't be tolerated, as small differences in percentage returns, over time, can compound into major differences in investment values. Ratings database was screened for ETFs meeting these criteria:

  • Annual total expense ratios of 0.25% or less.
  • Average bid/asked spreads of no more than 2 cents over a recent two-day sampling period.
  • Premiums or discounts from net-asset-value average no more than 0.20% during January of 2008.
  • Average daily trading volume of at least 500,000 shares for the period of December 2007 through January 2008.
  • ("HOLDRS" funds, which share some characteristics with ETFs but have different cost structures, were not included in this study.)

    Based on the above criteria, three funds at the top of the accompanying table were determined to be "Super-Cost-Efficient ETFs" while 21 others met the constraints and thereby qualified as being "cost-efficient."

    The trio of super-cost-efficient funds each:

  • 1) levies its shareholders no more than 0.15% annually in expense;
  • 2) traded in January at an average of no more than 0.10% from its net asset value per share; and
  • 3) experienced a bid/asked spread of no more than 1 cent during the tests.
  • The term "conservative" best characterizes the three super-cost-efficient ETFs, with a short-term Treasury bond fund keeping company with a pair of large-cap equity funds.

    The iShares Lehman 1-3 Year Treasury Bond Fund (SHY) invests in arguably the safest, steadiest investments outside of short-term Treasury bills. Yet, it enriched its holds by 8.95% during the low-interest environment that prevailed during the 12 months ended Jan. 31. The iShares Russell 1000 Index Fund (IWB) replicates the large-cap Russell 1000 gauge. Although its benchmark has double the population of the index followed by the third ultra-thrift-conscious ETF, the SPDR S&P 500 ETF (SPY), the portfolio dominance of both by large-cap stocks kept their respective investment returns for the 12 months ended Jan. 31 almost identical.

    The largest holdings for both IWB and SPY are Exxon Mobil (XOM - Get Report) and General Electric (GE - Get Report). SHY invests in a portfolio of U.S. Treasury notes maturing in one to three years.

    Each of the super-cost-efficient ETFs averaged more than a million shares a day of turnover during the period from Dec. 2007 to Jan. 2008. Hefty trading volume tends to keep a lid on premiums and discounts of market price vs. net asset values.

    An ETF trading half a million shares per day, on average, is almost certain to have the market liquidity to easily accommodate trades involving blocks of shares equivalent to creation or redemption units.

    But many ETFs are trading at much slimmer levels.

    Of 629 ETFs tracked by Ratings for which December 2007-January 2008 average daily turnover rates are available, 350 averaged less than 50,000 shares per day changing hands. Thirty-five funds averaged less than 1,000 shares per day; four traded at an average pace of only 150 shares per day.

    Thus, the average ETF lacks the market liquidity needed to handle creation and redemption units that help keep its price and net asset value in line. An investor who buys an ETF when it is priced at a premium, then sells when it is trading at a discount, is losing on both ends of the round trip.

    This underscores the importance of checking the pace of trading when evaluating ETFs.

    The 21 additional cost-efficient ETFs listed in the table cover most of the popular investment styles, such as value, growth and "core" investments. Portfolio size bases, such as small-cap, mid-cap and large-cap, are also represented.

    Also, to help round out choices of fixed-income ETFs, there's the iShares Lehman 20+ Year Treasury Bond Fund (TLT).

    A variety of sectors are represented on the list, including consumer discretionary, consumer staples, financial services, health care, industrials, materials, technology and utilities.

    iShares Lehman 1-3Yr Treasury Bond Fd (SHY) B 1,049,300 0.10 0.15 0.01 8.95
    iShares Russell 1000 Index Fd (IWB) C+ 2,079,250 0.07 0.15 0.01 -2.69
    SPDR S&P 500 ETF (SPY) C+ 227,572,100 0.04 0.10 0.01 -2.66
    Consumer Discretionary Sel Sector SPDR (XLY) D+ 5,335,500 -0.01 0.23 0.01 -16.36
    Consumer Staples Sel Sector SPDR Fd (XLP) B 3,930,550 0.10 0.23 0.01 4.32
    DIAMONDS Trust (DIA) B 16,723,250 0.06 0.18 0.02 1.97
    Financial Sel Sector SPDR Fd (XLF) C- 110,863,550 -0.05 0.23 0.01 -19.33
    Health Care Sel Sector SPDR Fd (XLV) C+ 3,673,750 0.08 0.23 0.01 -0.74
    Industrial Sel Sector SPDR Fd (XLI) B+ 6,648,750 -0.04 0.23 0.01 5.04
    iShares Lehman 20+Yr Treasury Bond Fd (TLT) B 2,494,000 0.14 0.15 0.02 13.74
    iShares Russell 1000 Growth Index Fd (IWF) C+ 4,292,950 -0.09 0.20 0.01 0.06
    iShares Russell 1000 Value Index Fd (IWD) B 3,268,550 -0.16 0.20 0.01 -5.82
    iShares Russell 2000 Growth Index Fd (IWO) C- 4,353,850 0.00 0.25 0.02 -4.88
    iShares Russell 2000 Index Fd (IWM) D 94,948,600 0.15 0.20 0.01 -9.72
    iShares Russell 2000 Value Index Fd (IWN) D 3,723,300 0.09 0.25 0.02 -14.99
    iShares S&P 100 Index Fd (OEF) C+ 2,436,100 0.06 0.20 0.02 -0.59
    iShares S&P 500 Growth Index Fd (IVW) C+ 1,135,850 -0.04 0.18 0.02 -1.78
    iShares S&P 500 Index Fd (IVV) B- 3,031,150 0.03 0.09 0.02 -2.70
    iShares S&P Mid Cap 400 Index Fd (IJH) C 506,300 0.03 0.20 0.02 -2.46
    iShares S&P Small Cap 600 Index Fd (IJR) D+ 1,780,750 0.09 0.20 0.02 -7.70
    Materials Sel Sector SPDR Fd (XLB) B+ 11,515,850 -0.08 0.23 0.01 12.39
    PowerShares QQQ (QQQQ) C- 170,508,900 0.09 0.20 0.01 2.70
    Technology Sel Sector SPDR Fd (XLK) C 3,755,250 0.03 0.23 0.01 -1.30
    Utilities Sel Sector SPDR Fd (XLU) A+ 6,567,500 0.17 0.23 0.01 10.12
    (1) Average daily trading volume for Dec. 2007 - Jan. 2008.
    (2) Average premium or discount of market price to net asset value during Jan. 2008.
    (3) Spread between bid & asked during trading on Feb. 22, 2008.
    (4) For 12 months ended Jan. 31, 2008.
    Sources: Ratings & Bloomberg.
    Richard Widows is a senior financial analyst for Ratings. Prior to joining, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.

    Widows holds long-term positions in the Powershares QQQ and the Technology Select Sector SPDR.

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