Exchange traded funds, or ETFs, have become incredibly popular investment products in the twenty years since they were first launched in Australia. There are now 322 exchange traded products listed on the ASX and Cboe Australia with over $120 billion in funds under management.

Investors and their advisers have a plethora of products to choose from and many advisers are using ETFs in their model portfolios for clients. While we understand that financial advisers, due to their increasing regulatory and compliance burden, are also increasingly time poor, we still argue that it is important for them to take a close look at what is ‘under the hood’ of the products they are recommending to clients, especially when it comes to ETFs.

The true cost of ownership

One thing that needs closer examination is the true cost of owning an ETF. While the management costs (which often include the investment manager and the responsible entity’s fees) and transaction costs should be made clear in a product disclosure statement (PDS), other costs – such as opportunity cost and implied transaction costs – are not.

Explicit transaction costs are usually estimated in a PDS and refer to the specific sum, or percentage, that is paid to known parties to carry out a transaction. They usually include broker commissions, taxes and exchange fees. But they are not the only costs involved in buying and selling shares for an ETF.

Implicit transaction costs include other indirect costs such as the impact of the trade on the price received. Factors such as the difference between the bid and the ask prices (the bid-ask spread), market impact, delay and unfilled trades all contribute to implicit trading costs.

Arguably, Australia has a bit of catching up to do with regards to capturing some of these costs for the investor. The UK already endorses an effective spread approach. The effective spread is two times the difference between the trade price and the mid-quote price before the trade occurred. However, this is not currently captured under the ASIC’s Regulatory Guide 97 which provides guidance on how fees and costs should be disclosed in PDSs and periodic statements.

The legitimacy and relevancy of including this cost in PDSs is justified, with a review of disclosure guidelines overdue. The bid-offer spread reflects the liquidity of the product and is a real cost that clients are incurring that is not required to be disclosed. Poor execution means client pay, and poor action by market makers also results in clients paying an excessive non-disclosed cost.

Market impact – or the impact of the market knowing what you are doing – is another implicit cost. If it is telegraphed to the market that an ETF provider is about to buy a large chunk of a particular equity, sellers of that stock may push up prices, particularly with passive rebalances. Market impact can be minimised by good trading hygiene, such as knowing the market and the use of “dark pools” – where large block trades can be made anonymously – to minimise transmitting intentions.  This also applies to executing buy/sells for the ETFs themselves, especially given relatively low liquidity on average in the ETF segment.

Brokers have a legal requirement to find the best execution or the most advantageous order of execution for their client. Part of this is managing both the explicit and implicit transaction costs. The urgency of the trade, which is a function of both market liquidity and expected price movement, can be as important as its price. This is especially pertinent when it comes to selling a security that is about to lose its value completely or buying a security that increases significantly in value.

That is why “managing” is a more appropriate term than “minimising” when it comes to transaction costs and best execution.

What’s in the box?

There should also be a reasonable understanding of the underlying assets in an ETF. Are they real assets, derivatives or structured notes? Are they affected by current geopolitical situations? A good example in the current environment is a corporate bond ETF. If an ETF had Russian corporates in it, it could face the possibility of those assets being frozen to half the world while the current war between Russia and the Ukraine wages on.

Another example is the US VIX index ETFs. These are not products designed to be held for a long period of time by the average investor. Rather, they are used by investors for quick entry and exit strategies. The costs of holding them for long periods of time will wipe out any investment gains and or your capital.