Morningstar investigated a range of European-domiciled smart/strategic/alternative beta ETFs, compared those to plain-vanilla ETFs and found the former are significantly more expensive. The largest cost difference was found for ETFs benchmarked to the S&P 500. While US market cap-weighted ETFs are the world’s cheapest at an average TER of 0.14%, their smart beta equivalents are among the world’s most expensive at an average TER of 0.43%.
Only adding to the cost gap between smart beta ETFs and their plain vanilla peers is the fact that the former tend to have higher turnover and trading costs, Morningstar points out.
“Because many strategic beta ETFs are relatively new, small, and often used as buy-and-hold investments, they may have low trading volume and show wider bid-ask spreads,” its report states. The average smart beta ETF benchmarked to the S&P 500 has a bid/ask spread of 0.40%, compared to 0.14 for a market-cap weighted index-tracker.
The most expensive smart beta ETF Morningstar identified is the PowerShares Dynamic US Market ETF, which has a TER of 0.75% and an average bid/ask spread of 0.58%. This contrasts sharply with the equivalent numbers of 0.05% and 0.07% for the cheapest tracker they found: the Source S&P 500 ETF.
For European and emerging market equities, the differences are actually a lot smaller, mainly because plain-vanilla index trackers are not as cheap as for US equities. However, smart beta ETFs tracking European equity markets also are on average 10 basis points cheaper than their US equivalents.
And the gap keeps widening…
But are providers doing anything to mitigate the cost gap between smart beta and market cap-weighted ETFs? Well, fees for smart beta ETFs have decreased somewhat over the past two years. But that’s only due to new, simpler and cheaper products coming to the market. Unlike their plain vanilla peers, which have become a lot cheaper as a consequence of increased competition, providers have not cut fees for smart beta ETFs, says Morningstar.
Therefore, concludes the investment research company, investors “should have high conviction on the merits of the underlying strategies and carefully assess whether the higher costs sustained might severely impair long-term performance.” If they are in doubt, they should probably go for the devil they know, and stick with dumb beta.