Investing in emerging markets is usually significant more costly tracking a major developed markets. Explicit expenses such as custody and trading fees are generally higher, as are the implicit costs of operational challenges. Many of these costs will not be reflected in an ETF’s total expense ratio, as discussed in part one of this feature. So how much extra should investors expect for EM indexing and where do some of the hidden costs lie?
The lowest current cost for a broad EM ETF is almost certainly that achieved by the $54 billion (€41 billion) Vanguard Emerging Markets ETF. This had a total expense ratio (TER) of 0.18 per cent in the year ended October 2012 and total tracking difference of -0.19 per cent. It follows a full replication approach, so the impact of optimization strategies on tracking difference should be low.
According to the annual report, the fund also earned securities lending revenues equal to around 0.08 per cent of average net assets, suggesting it had tracking difference of 0.27 per cent before benefiting from this additional income. About 0.12 per cent of costs reflected management, administrative and marketing fees, while around 0.05 per cent was custody costs. This suggests that transaction costs, taxes and operational complexities added about 10 basis points to tracking difference.
Like most ETFs, this tracks the net total return version of its index, so dividend withholding tax would not have been a source of tracking difference. However, it’s interesting to note that withholding taxes amounted to around 0.29 per cent of average net assets and around 11 per cent of dividends received.
Tracking difference varies over time and in 2012 it was exceptionally close to the TER. However, the five year average for the fund was a TER of 0.21 per cent and a tracking difference of -0.28 per cent. This period includes the highly volatile markets of late 2008 and early 2009.
As assets have increased over this period, the relative contribution from management and admin costs has unsurprisingly dropped. Custody costs seem to have remained fairly steady at around 5 basis points. After allowing for lending revenues, the unexplained five-year average tracking difference still appears to be around 10 basis points.
So in what is likely to be the most efficient EM index fund, replication seems to cost around 10 basis points more than the TER, although some of this can be offset through enhancement strategies.
Comparing costs across markets
Vanguard is obviously an unusual case, given its mutual ownership structure, its focus on minimizing costs and the fact that its emerging markets offering is a single very large fund. To see how costs vary across a range of products in a more conventional environment, the db x-trackers range provides some useful examples.
These ETFs cover a wide range of emerging markets and use a consistent fee structure. On equity ETFs, the firm charges a fixed fee of 0.2 per cent and a management fee (usually 0.3-0.75 per cent), leading to a TER of 0.5-0.95 per cent on most funds. There is no initial swap spread, but since 2010 Deutsche has passed on costs for some funds in the form of swap adjustments.
Most developed market ETFs in the X-trackers range have not been subject to an adjustment, so – assuming that Deutsche’s swap desk gives its ETF arm the market price for swaps – the swap adjustment for EMs should give some broad idea of the added costs of replication. These adjustments are detailed in the annual report and figures for selected products are shown below.
|Index tracked||TER||Swap Adjustment 2011||Swap Adjustment 2012|
|CNX Nifty||0.85%||10 bps||20 bps|
|MSCI Taiwan||0.65%||3 bps||24 bps|
|MSCI Korea||0.65%||4 bps||25 bps|
|MSCI Brazil||0.65%||15 bps||28 bps|
|MSCI Mexico||0.65%||15 bps||32 bps|
|MSCI Emerging Markets||0.65%||21 bps||35 bps|
|MSCI Russia||0.65%||23 bps||41 bps|
|MSCI Vietnam||0.85%||38 bps||41 bps|
|MSCI Bangladesh||0.85%||318 bps||44 bps|
|S&P Select Frontier||0.95%||68 bps||50 bps|
|MSCI Pakistan||0.85%||58 bps||145 bps|
|CSI 300||0.50%||None||251 bps|
In total, 46 emerging market-related ETFs received a swap adjustment in 2012, with a typical adjustment being in the range of 20-30 basis points. These indicate that there has been a meaningful additional cost not captured in the TER, even for the more mainstream emerging markets. These extra costs are unsurprisingly greater for frontier markets such as Vietnam, Bangladesh and Pakistan.
The A share expense
The most significant excess costs are those incurred by the mainland China A share trackers such as the CSI 300 index (sector ETFs for the same index received adjustments of a similar size). In this case, the swap cost far exceeds the TER.
This isn’t a case of db x-trackers being uncompetitive. Other than the new RQFII ETFs run by Chinese managers that launched last year (with too little history to compare), access to the A share market for offshore ETFs must be done through swaps or P-note-type products and is extremely costly.
For example, the US$6.8 billion iShares FTSE China A50 carries a management fee of 0.99 per cent and a headline TER of 1.39 per cent. But full costs, as disclosed in the iShares Asia Trust annual report, are much greater, especially since changes to collateralisation rules in August 2011 increased its collateral costs.
The A150 ETF had an additional collateral cost of 1.63 per cent in 2012, while those for some of iShares’ smaller A share ETFs are even greater. For its CSI 300 Financials tracker, the figure was 3.81 per cent – almost three times its reported TER.
The impact of this on performance is obviously enormous. For example, the iShares CSI 300 Financials ETF has lagged its index by more than seven percentage points in net asset value terms over the past year. While these A share ETFs are obviously an extreme example, some other EM products can underperform by 1.5-2 percentage points per year after costs – a drag that can’t be ignored even if it is unavoidable.
While no single measure can perfectly indicate the costs of owning a fund, there must surely be a case for including an estimate of large ongoing costs in headline expense ratios. Until that happens, investors certainly need to make sure they look beyond the TER.