Not too long ago, there was an obvious way to construct a broad, low-cost ETF portfolio for clients: Turn to Vanguard. Then Schwab and iShares entered the fray -- possibly because Vanguard was collecting 32.4% of all new investor money into ETFs. One of the two giants lowered expense ratios; the other launched new ETFs to compete with Vanguard. Although the fee war has been great for clients, selecting the right ETFs isn’t just about expense ratios. Here’s what you need to know.

Schwab’s Gambit


Schwab made the first move in September when it filed with the SEC to lower the expense ratios of its ETFs dramatically. Suddenly, Vanguard no longer had the lowest expense ratios for diversified stock and bond portfolios. Schwab’s new annual expense ratio for the U.S. broad market fund (SCHB) is only 0.04%, for instance, besting Vanguard’s 0.06%. Its international index fund (SCHF) expense ratio of 0.09% is also lower than Vanguard’s, while the Schwab U.S. aggregate bond market ETF (SCHZ) expense ratio of 0.05% is half Vanguard’s 0.1% expense ratio.


It was a bold competitive move. At the time, Schwab had only $7.5 billion in ETF assets -- a far cry from Vanguard’s $221 billion in ETF assets (and $645 billion in all index asset classes).
And it could be tricky for Vanguard to respond. Vanguard’s ETFs and mutual funds are different share classes of the same fund. So for Vanguard to match Schwab’s new fees would be extremely costly, as they would likely have to do it for an asset base nearly 100 times larger than Schwab’s. Although critics speculated that Schwab was using its ETFs as a loss leader, Schwab’s managing director of ETFs, Eric Pollackov, denied it; he said the company is committed to low-cost ETF investing and expects its ETF businesses to be profitable.


In October, Vanguard announced its own initiative to lower expense ratios over the longer term by switching target benchmarks on 22 index funds to CRSP from MSCI. The lower licensing fees will allow Vanguard to pass the savings through to fund shareholders.
All that wrangling left a dilemma for BlackRock’s iShares, the largest provider of ETFs (with a half-trillion dollars under management), which had already been losing share to Vanguard. Lowering fees to match would cost BlackRock $259 million annually, according to Matt Hougan, president of ETF analytics at IndexUniverse. Yet if iShares left fees intact, the company would keep losing share.


BlackRock’s response was to launch new ETFs known as core ETFs to compete with Vanguard and Schwab. The iShares Core ETFs are marketed to buy-and-hold investors, and generally matched Vanguard’s expense ratio -- a bit higher in equities and lower in fixed income. That solved BlackRock’s problems but shifted the challenge to advisors and consumers. To get the lower expense ratios, advisors would need to sell clients’ existing iShares ETFs, possibly triggering capital gains.


The upshot: In a remarkably short period, the playing field for the lowest-cost ETFs has changed dramatically. (Notably, State Street, the second-largest ETF provider has remained on the sidelines.) The winners, of course, are clients; the lower fees will result in higher returns. Below is a snapshot of the current playing field of the broadest ETFs.


If expense ratios were the only factor in fund selection, there wouldn’t be much more to say, and Schwab would be the easy choice. But other issues are perhaps even more important. One key consideration is how an index fund is constructed. For example, Vanguard and iShares international index funds include developed and emerging markets, as well as
large-, mid- and small-cap companies. But the Schwab international index fund only includes developed countries and leaves out small-cap companies.


Another factor is costs, including the bid/ask spreads as well as premiums and discounts paid in buying and selling. These costs are often many times the annual expense ratio of these low- cost funds. There is also the question of tracking error -- how well the funds deliver the index returns. Smaller funds, for instance, must do more “optimization.” That’s another word for sampling -- which, of course, brings sampling error.


IndexUniverse’s ETF Analytics Tool looks at these factors and assigns an overall score, as well as a score for every fund by factor: efficiency (fund construction), tradability (cost to buy and sell) and fit (measures tracking). Here’s the analysis for each category.


U.S. Equities


Each of the three U.S. stock funds gets an A grade. Vanguard is the giant here, with $23 billion in ETF assets and about $200 billion across all share classes of this fund. Vanguard’s average spread, at 0.02%, is half that of Schwab’s. If these averages hold, then a one-year holding period would result in about 0.08% in expense ratios and spreads in each fund.


Vanguard, however, has bested Schwab’s past performance, in part due to a negative tracking error that Pollackov admitted the Schwab fund had over the past year. By measuring the impact of the premium and discounts over its NAV by subtracting the largest discount from the largest premium, you effectively get the maximum penalty a client would have paid if they bought at a premium and sold at a discount. The Schwab fund slightly bested Vanguard in this category. The iShares fund, meanwhile, badly lagged and received the lowest tradability score. This is technically not a new fund; it was previously the iShares S&P 1500 Index Fund.

International Equities


No fund gets an A grade here. In the chart, you’ll find three different international funds for Schwab since it would take all three to build as broad a portfolio as the iShares and Vanguard funds. None of the international funds are particularly liquid, with spreads ranging from 0.11% to 0.59% and maximum bid/ask spreads ranging from 1.25% to a whopping 5.27% .

 


The Vanguard fund is also the giant in this asset class, with $74.2 billion across all share classes (helping minimize tracking error), though it has only $1 billion in the ETF share class. The Vanguard fund slightly bested the weighted average performance of the three Schwab funds that would be required to build a global non-U.S. fund. So with slightly better bid/ask spreads, the Vanguard fund appears superior for both short- and long-term holding periods.


The iShares product is new and may become a superior option over time, though the 0.59% average spread now makes it more similar to a loaded fund.

Aggregate Bonds


These funds, all of which track the Barclays aggregate bond index, get A and B grades. Rather than launch a new bond fund, iShares lowered the expense ratio of its existing aggregate bond fund to 0.08% from 0.2%. This fund is nearly as large as Vanguard’s, although Vanguard totals a larger $115 billion across all share classes of the fund.


IndexUniverse gives the only A in the category to iShares. While Vanguard has had better performance, it was during a period when iShares had a higher expense ratio, and that’s no longer true. The spreads are the same, and Index-
Universe didn’t track the premium and discounts, which Hougan says can be misleading in this category. As for Schwab, its fund is too illiquid, with a spread eight times larger than its counterparts at iShares and Vanguard. Also, its relatively small size makes tracking error a concern.


Commissions and Construction


There’s one last factor to consider: commissions. While all ETFs generally have the same commissions within each firm, each of these three families of ETFs can be purchased commission-free. Schwab and Vanguard both waive commissions for funds bought through their brokerage operations, while Fidelity waives commissions on 30 iShares ETFs.


When it comes to selecting narrower ETFs, meanwhile, exercise caution in portfolio construction. Vanguard’s emerging market ETF, for instance, will soon exclude South Korea, which will be added to its developed market index fund, while iShares and Schwab will include it in emerging markets. Combining an iShares emerging market ETF with a Vanguard developed market ETF would have double the exposure to South Korea.


As expense ratios continue to approach zero, ETF fee wars have been great for clients. But look beyond to also examine the efficiency, tradability and fit of each ETF in order to build superior portfolios for your clients.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at the University of Denver.