Are you better off with commission-free ETFs? James DiLellio, PhD Pepperdine University Phil Goldfeder, PhD Northwestern University
Introduction Competition amongst discount brokers continues to reduce trading commissions. Many firms now offer $0 commission trades on many Exchange Traded Funds (ETFs). Ameritrade, Fidelity, Schwab and Vanguard.
Motivation How much do other costs marginalize the commissioncomponent of the total cost incurred by an individual investor? Expense ratios the cost funds charge, as a percent, of an investor s holdings, to manage the ETF. Bid-ask spread the price difference between the highest a buyer is willing to pay and the lowest a seller is willing to sell. Portfolio turnover in the context here, the amount that an individual investor buys and sells, relative to their total portfolio holdings. For buy-and-hold investors, turnover = 0%. Are the $0 commissions worth moving assets from one broker to another?
Why the bid-ask spread matters when volumes are low Fig 2. Bid-ask spread, in basis points versus three month moving average volume Source: DiLellio and Stanley (2011) ETF trading strategies to enhance client wealth maximization. Financial Services Review, p. 145-163.
$0 Commission ETFs offered as of June 2014 Ameritrade 101 ETFs from 8 different fund companies, including ishares (47), Vanguard (32), Market Vectors (3), Barclays Funds (1), PIMCO (1), PowerShares(4), SPDR(12), WisdomTree(1) Fidelity 65 ishares ETFs, (1) Fidelity Nasdaq index ETF S 119 ETFs from 6 different fund companies, including Schwab(21), SSGA (31), Guggenheim(43), PowerShares (14), ETF Securities (6), US Commodity Funds (4) Vanguard 52 Vanguard ETFs
ETF Architecture From WSJ, 3 Feb 2013
ETF Architecture Vanguard offers ETFs as a separate share class of an existing index mutual fund Creates economies of scale and keeps costs down? Evidence to follow. PIMCO offers an ETF that is independent of other firm s mutual fund offerings. State Street Global Advisors (SSGA) connects ETFs to a mutual fund in a master-feeder design. ETFs are not all created equal.
Implications of Vanguard s ETF structure Recent study by Agapova (2010) in Journal of Index Investing demonstrated: Vanguard ETFs and corresponding index mutual funds are not substitutes. Flows of ETF and mutual funds by vanguard positively effect each other.
Ameritrade Commission-Free ETFs, 101 total 32 Domestic Equity Funds Size and Style (e.g. Value-Growth, Small-Mid-Large Cap) Allocation funds that blend equity with fixed income Dow Jones Global Real Estate (?) 2 Sector Funds SPDR & Vanguard REITs 33 Bond Funds Various terms to maturity (short, intermediate, long) Treasuries, Mortgage Backed, Corporate, Muni, International, TIPS 31 International Funds Developed and Emerging Markets Country specific (e.g. Australia, Germany, etc.) Regions (BRIC, Europe, Latin America, etc.) International Real Estate 3 Commodity Funds Broadly defined and Oil
Fidelity Commission-Free ETFs, 66 total 17 Domestic Equity Funds Size and Style (e.g. Value-Growth, Small-Mid-Large Cap) Nasdaq tracking fund Real Estate, Preferred stock and minimum volatility 25 Bond Funds Various terms to maturity (short, intermediate, long) Treasuries, Mortgage Backed, Corporate, Muni, International, TIPS 20 International Funds Developed, Emerging and Frontier Market equity Country specific equity (e.g. China, India) Regional international equity (BRIC, Europe, Latin America, etc.) International Real Estate 4 Commodity Funds Broadly defined and Oil
Schwab Commission-Free ETFs, 120 total 21 Domestic Equity Funds Size and Style (e.g. Value-Growth, Small-Mid-Large Cap) Multi-asset that blends equity with fixed income Others (defensive, equal weight, fundamentals, low volatility, high beta) 11 Sector Funds Consumer discretionary, Healthcare, etc. 37 Bond Funds Various terms to maturity (short, intermediate, long) Treasuries, Mortgage Backed, Corporate, Muni, International, TIPS, Junk Developed and emerging International, other (floating rate, convertibles) 31 International Funds Developed, Emerging and Frontier Markets. Some style and size options. Country specific (e.g. China, India, Japan.) Regions (BRIC, Europe, Latin America, Middle East & Africa) Specialty (8) and Real Assets (12) World currencies (Euro, Pound, Yen, ) Broad commodities, precious metals, REITs
Vanguard Commission-Free ETFs, 52 total 17 Domestic Equity Funds Size and Style (e.g. Value-Growth, Small-Mid-Large Cap) 11 Sector Funds Consumer discretionary, Financials, Health care, Utilities, etc. REIT 15 Bond Funds Various terms to maturity (short, intermediate, long) Treasuries, Mortgage Backed, Corporate, TIPS International 9 International Equity Funds Developed and Emerging Markets Regions (Pacific, Europe)
Methodology to compare commission free ETFs Find a common set of ETFs in broad categories. Evaluate the potential costs of holding portfolios in these categories using a passive or active portfolio management approach. Recognize that additional return performance can be obtained by seeking out portfolio holdings that include ETFs not in these broad categories. As shown by DiLellio and Stanley (2011): Beware to benchmark portfolio to gauge any excess returns over an appropriate benchmark. ETF-only strategies with excess returns are made possible by providing exposure to asset classes that were either previously unavailable or contained in mutual funds with significantly higher fees and execution problems.
Initial Screening Selected three major asset classes Domestic Equity, International Equity and Fixed Income. Excluded Sector-specific, Commodity, Specialty, and Real Asset funds. Supports a more direct comparison between brokerages. Aggregate Sample and Expense Ratios Aggregate Ameritrade Fidelity Schwab Vanguard sample size 94 59 83 40 mean expense ratio 0.29% 0.33% 0.37% 0.12% median " " 0.20% 0.25% 0.32% 0.12%
Expense ratios for $0 commission ETFs in three asset classes Fixed Income ETFs Ameritrade Fidelity Schwab Vanguard sample size 33 25 37 15 mean expense ratio 0.22% 0.26% 0.33% 0.13% median " " 0.15% 0.20% 0.30% 0.12% Domestic Equity ETFs Ameritrade Fidelity Schwab Vanguard sample size 31 15 21 17 mean expense ratio 0.19% 0.25% 0.28% 0.10% median " " 0.15% 0.20% 0.25% 0.10% International Equity ETFs Ameritrade Fidelity Schwab Vanguard sample size 30 19 25 8 mean expense ratio 0.46% 0.48% 0.50% 0.16% median expense ratio 0.53% 0.50% 0.46% 0.16%
Implications for buy-and-hold investors An investor who buys and holds for extended periods will be most sensitive to expense ratio. For broadly defined asset classes of Domestic Equity, International Equity and Fixed income, Vanguard is the optimal choice. But, what if an investor wishes to trade periodically? Will $0 commissions offset potentially higher bid-ask spreads?
Cost Model total cost = holding costs + buy/sell costs. Where holding costs = investment amount * holding period * expense ratio buy/sell costs = bid-ask spread costs + commission costs (if any)
Data Sources Center for Research in Security Prices (CRSP) database queried for time-series data from January 1, 2007 to June 30, 2013 Daily returns Daily volume Daily average bid-ask spread Daily price (open, close, high, low) Shares outstanding
Reduced sample size to create a diversified portfolio As suggested in Arshanapelli (2010), a correlation threshold can be applied against return correlations to generate a diversified portfolio. We refined this approach to also include volume, where higher volume ETFs are preferred. Only include ETFs with > 6 months of daily returns. Ameritrade Fidelity Schwab Vanguard Fixed Income sample size, r 30 23 35 12 0.90, n T 124* Domestic Equity, sample size, r 5 2 4 1 0.90, n T 124* International Equity, sample size, r 7 8 11 2 0.90, n T 124* * Minimum period chosen to include funds traded for > 6 months
Seeking the best factor model for bid-ask spread Ameritrade Fixed Income ETFs
Seeking the best factor model for bidask spread Fidelity Fixed Income ETFs
Seeking the best factor model for bidask spread Schwab Fixed Income ETFs
Seeking the best factor model for bid-ask spread Vanguard Fixed Income ETFs
Goodness of fit for single factor models of bidask spread from each diversified portfolio Goodness of fit for single factor models of bid-ask spread from each diversified portfolio Fixed Income ETFs Ameritrade Fidelity Schwab Vanguard ln(volume) 22.1% 43.6% 9.0% 30.0% ln(shares outstanding) 14.9% 44.0% 11.5% 12.7% ln(market capitalization) 22.0% 43.5% 16.4% 11.3% Domestic Equity ETFs Ameritrade Fidelity Schwab Vanguard ln(volume) 51.6% 64.5% 0.1% 4.8% ln(shares outstanding) 70.1% 78.5% 1.1% 20.3% ln(market capitalization) 67.7% 80.4% 2.2% 23.5% International Equity ETFs Ameritrade Fidelity Schwab Vanguard ln(volume) 16.7% 10.7% 27.7% 25.4% ln(shares outstanding) 20.7% 21.6% 32.9% 24.7% ln(market capitalization) 30.5% 29.7% 34.8% 27.0% Vanguard s ETF structure may explain why market cap isn t the best predictor of the bid-ask spread.
Implications of best-fit models to predict transactions costs If focused on any single criteria, market capitalization is the best single measure to keep costs down. Market capitalization = shares outstanding * share price Higher market cap generally leads to lower spreads. But, there are other sources that may also contribute to spread. Broker used, size of order, time of day, Nevertheless, to reduce uncertainty in trading costs and keep them down, ETFs with a small market cap should be avoided, when possible. Vanguard may be an exception, due to their ETF architecture.
Portfolio turnover and management One passive management technique that has gained recent attention is the 1/n or Naïve allocation. (See Demiguel et al, 2009, Review of Financial Studies) An investor identifies the n securities of interest, and makes an initial investment of 1/n of their total investment in each security. Due to changes in prices, the portfolio can be periodically rebalanced to the 1/n target. This approach was used for portfolios from each discount broker and in each broad asset class Fixed Income, Domestic Equity, International Equity Future prices were simulated as a Geometric Brownian Motion (GBM) process, and correlation amongst investments were included. Simulated results indicate the extent that a passive management of ETFs could increase portfolio management costs
Turnover Rates for the 1/n portfolio with periodic rebalancing Fixed Income ETF portfolios Fixed Income Portfolios n Annualized mean return (assumed) Portfolio Standard Deviation, Annualized (sampled) Number of Rebalancing Periods Per Year 1 2 4 6 12 Ameritrade 30 4% 3.1% 2.4% 3.3% 4.6% 5.6% 7.8% Fidelity 23 4% 3.2% 2.0% 2.8% 3.9% 4.7% 6.6% Schwab 35 4% 2.4% 1.7% 2.4% 3.4% 4.1% 5.7% Vanguard 12 4% 4.2% 2.1% 2.9% 4.0% 4.8% 6.7% Less turnover occurs for a Schwab portfolio of fixed income ETFs. More turnover occurs for a Vanguard portfolio fixed income ETFs.
Turnover rates for the 1/n portfolio with period rebalancing Equity ETFs Work in progress But, we expect that the turnover rate of a domestic or international equity portfolio will be linearly related to the portfolio standard deviation, size and number of rebalancing periods per year. The annual volatility of equities is Domestic: <15% International: <20% Using an least-squares approach on fixed income simulated data suggests that a portfolio of Domestic ETF with 5 or fewer holdings should yield approximately a 32% turnover. Similarly, a least-squares approach with International ETFs and 11 or fewer holdings should yield approximately a 45% turnover.
Consider other investment strategies Passive management may help transaction costs, but more active strategies are often used. Does a more active strategy change the cost calculus? Recall: total cost = holding costs + buy/sell costs. Where holding costs = investment amount * holding period * expense ratio buy/sell costs = bid-ask spread costs + commission costs (if any)
Annualized cost rate of a fixed income ETF portfolio ($0 commissions) Passive Management Active Management
Annualized Cost, including $7 commissions, for the Vanguard Fixed Income Diversified Portfolio, Rebalanced to the 1/n allocation. Number of Rebalancing Periods Per Year Investment Amount $100,000 $200,000 $500,000 $1,000,000 1 19.7 15.5 13.0 12.2 2 28.2 19.8 14.8 13.1 4 45.1 28.3 18.2 14.8 6 62.0 36.8 21.6 16.6 12 112.5 62.1 31.9 21.8
Key observations These results suggest the following, based on a reference point of approximately 24 basis points, which was selected because it is where the non-vanguard $0 commission ETFs costs begin. For investors with a $100,000 investment, investors can pay a brokerage fee of $7 a trade and make annual re-balancing, while still having a lower annual cost than using the other $0 commission discount brokers. But, more frequent re-balancing would negate this benefit. For investors with more than $100,000 to invest, they can continue to spend $7 to trade Vanguard ETFs and still have lower annualized costs than using the other $0 commission discount brokerages. The more invested, the more frequent periodic re-balancing can occur while keeping the annualized cost lower than competitors offering $0 commissions. For a $200,000 investment, rebalancing can occur up to two times per year. For a $500,000 investment, rebalancing can occur up to four times per year. For a $1,000,000 investment, rebalancing can occur up to six times per year.
Conclusions and future work Expense ratios are the dominant cost of $0 commission fixed income ETFs when turnover rates remain low. E.g. Under a naïve rebalancing strategy for fixed income ETF portfolios Applying the best single factor models to estimating the effect of higher turnover rates in fixed income ETFs produce similar cost increases amongst discount broker. Overall, Vanguard offers the lowest overall costs of fixed income $0 commission ETFs, but also offers the fewest investment options. Vanguard s lowest cost is eliminated versus its competitors if a nominal commission for rebalancing is incurred for more frequent rebalancing and/or smaller investment amounts.
Additional Work Evaluate turnover rate of 1/n portfolios for domestic and international equity ETFs See if low turnover rate persists, or if higher volatility of equity funds produces significant rebalancing costs. Identify other factors to better explain bid-ask spreads costs Multi-factor models Forecast buy-sell costs to evaluate robustness of findings under future market conditions.
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