Pulling the Curtain Back on ETF Cost ­Efficiency

In fact, having investors who trade more actively helps narrow the spreads, and if buy-and-hold investors look to sell or purchase more shares, they can save additional money. Trading among active shareholders can also cause an abundance or shortage of inventory, requiring the market maker to go to the ETF provider directly to create or redeem shares.

For most ETFs, the process for creating and redeeming shares is done "in kind," which involves less cost to fund shareholders by not having to buy or sell any underlying securities. The market maker pays the cost to move those shares directly in and out of an ETF. In doing so, the market maker is an authorized participant that pays a creation unit fee, which is listed in any ETF prospectus. None of these costs impacting an ETF are borne by passive shareholders, who instead benefit from narrower spreads and better tax efficiency.

Those are real cost savings not displayed in the expense table of an ETF. For example, let's use actual long-term capital gain distributions from 2012 in a $7 billion index mutual fund—U.S. domestic equity large blend—that pays a $0.06 capital gain on $10.69 NAV, which equals a 56 basis point annual distribution. Since the distribution is a long-term gain, let's assume a 15% tax rate that translates into a real investment loss of 8.4 basis points. Take into consideration that this index mutual fund has a seven basis point total expense ratio. If the fund's strategy was offered in the more operationally efficient ETF structure, it has the potential to save at least 8.4 basis points if not more from the internal drag of the transactions. Such a scenario in effect would offer the mutual fund strategy in an ETF structure for free.

To be clear, it's normal for a fund to have taxable distributions. However, an investment strategy delivered in an ETF vehicle could present significant positive impact on your clients' long-term returns.