The Driveaway Price
If you’ve ever bought a new car, you’ll know there can be a gulf between the sticker price that pulls you in and what you actually end up paying. For investors the sticker price is analogous to the expense ratio, while the actual cost of the car is the total cost of ownership.
With the rise of indexing, the expense ratio is often the first thing investors look at in choosing a fund. In the case of an index, you have to dig far deeper than the expense ratio to actually get to the true total cost of ownership. These costs may be meaningful, and ultimately reduce returns to the investor. A cost-conscious manager looks to mitigate all costs. Let’s look at a few:
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Trading Costs – Is the index manager seeking to minimise transaction costs through efficient portfolio design and trading? Take index reconstitution events. At these times, index managers aim to minimise tracking error by trading in the close of that day. This means managers tracking the same index, can all end up trading the same stock on the same day and at similar times. The subsequent surge in volume and price pressure is well documented.1 Index fund investors can end up buying index additions at higher prices and selling index deletions at lower prices. These costs can be hidden, even if the index manager is transparent.
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Style Drift – Indices typically rebalance once or a handful of times a year, rather than throughout the year. Infrequent rebalancing between reconstitution dates may lead to holdings drifting from investors’ chosen asset allocation—a potential opportunity cost. For example, while you might expect the S&P/ASX Small Ordinaries index to primarily hold Australian small cap stocks, the overlap between the securities in that index and the largest 100 stocks averaged 10% between December 2009 and June 2023. For investors seeking to capture the returns of a particular market segment this potential opportunity cost is akin to ending up with a car you never intended to buy.
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Security Lending Shortfalls – Securities lending is a way a portfolio can earn additional revenue and enhance returns. Depending on how it is done, this can be a material percentage of the expense ratio given back to investors. However, practices vary, including among index fund managers, as to how much of securities lending income is returned to the portfolio as opposed to being kept by the manager. Revenue kept by the index manager is another shortfall (cost) that does not show up in the expense ratio.
All of these extras hidden below the bonnet can add up, so that the total cost of ownership of indices can be much higher than the advertised expense ratio. This is both because both of the way they are implemented and the lack of focus on the chosen asset category.
The Driveaway Price
This article originally appeared in Short N Sweet, a newsletter for Dimensional clients.
Footnotes
- 1. Kaitlin Hendrix and Trey Roberts, “Beware the Hidden Costs of Indexing”, Insights (blog), Dimensional Fund Advisors, June 23, 2022.
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