The Real Cost of S&P 500 ETFs (It’s Not What You Think)

"Just buy a low cost S&P500 index tracking fund....."

Most investors think buying a low-cost S&P 500 ETF is the smartest move they can make—but the 0.03% fee doesn’t tell the full story. 

In this episode, I break down the hidden costs, missed opportunities, and structural limitations of passive investing. 

If you’re relying on “cheap” as your strategy, this one might change how you think about it. 

If you have a question, suggestions, or a topic you would like us to cover, please send an email to: podcast@foxplan.nz

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The information shared on The Dollars & Sense Podcast is general in nature and does not consider your individual circumstances. Dollars & Sense exists purely for educational purposes and should not be relied upon to make an investment or financial decision. Tim Ellis (FSP778196) and Brodie Haggerty (FSP778174) are both Financial Advisers providing advice on behalf of FoxPlan Ltd. FoxPlan Ltd (FSP39630) is a licensed Financial Advice Provider. Important information can be found at www.foxplan.nz/disclosure 

Transcript

SPEAKER_00 0:00

When I go to Book of Flight, I know that there's two options I'm gonna look at. Those options are usually Jet Star or Air New Zealand. On the face of things, it seems pretty easy to work out that Jet Star is, by and large, mainly cheaper. Does that mean it's the best option? What I always, always remind myself once I go down that road is yeah, sure, I I choose the flight, but then I'm forced into a seat selection. And for anyone that doesn't know me, I'm six foot one, so I usually like to select the seat that has just a tiny bit extra leg room. There's an extra fee, of course. I need to be super conscious of my baggage. If it's uh a tiny bit over 7 kg, I'm gonna get hit with an$80 fee. I like to have a coffee on my flights. Usually I fly very early in the morning. I can have a coffee on a Jet Star flight, but I've got to pay for it. There's a hidden fee. I quite often travel with my children. Uh, in order to take a car seat and a pram, I'm gonna need to pay for oversized luggage. I don't get both of them for free, so there's a fee. And if I am traveling with my children, they're gonna need entertainment. Sometimes an iPhone or an iPad just doesn't quite cut it. So I can have an entertainment unit, but there's a fee. When it comes to choosing investment decisions, looking at different um cheap and effective ways of being an equity investor, it's quite often mentioned why don't you just buy a cheap SP 500 tracking ETF fund? On the face of it, it's a very cheap and effective way to become an equity investor, but there are some hidden fees. Welcome back to another episode of the Dollars and Cents podcast. As per usual, you're listening to myself, which is Tim Alice, on my own in the studio this week, putting together this podcast with the intention to increase the financial literacy of our listeners. Now, just before I get underway with this week's episode, which if you hadn't have guessed from the intro, I'm going to be looking at the hidden fees involved in buying a simple SP tracking index fund. I want to be super clear. This is not designed to be specific financial advice. We highly recommend that you seek the relevant professionals before making any financial decisions. With that out of the way, let's start unpacking this. What are the hidden fees? Why is it not as simple as the best thing you could do is simply buy an SP tracking ETF fund? The reality is, there's not one single financial advisor that I know in my network that makes sure that uh they recommend that every one of their clients just goes away and buys one of these funds. They're often recommending a far more complex solution. Why? There must be a good reason for it. Well, I'm gonna dive straight into it. I have three main points that I'd like to bring to the table. What I am not gonna be addressing in this episode is the value of advice. I'm not here to defend the advisor fee that you may or may not being charged. Uh, there's plenty of information about that and lots of justification and rationale. I've touched on it in uh previous episodes. Um I'm not gonna be uh reliving that one on this week's episode. If you do uh want to question the advisor fee, uh the host that I had on the show last week, Taylor Schulte, did a fantastic episode explaining exactly the value or the purpose of a financial advice fee and where it's not really appropriate and completely overcharged. Recommend if you want to uh dive into that topic, go back and have a listen to that episode. As for this week, I'm really just going to be looking at what are the hidden costs of having this simple solution of buying an uh an SP tracking ETF. Before we go into the hidden fees, uh let's get clear on what ETFs I'm actually referring to. I found two SP tracking uh ETFs that are very, very similar, very, very common, very well known. One is the iShare's core SP 500 ETF by BlackRock. The other is the uh the Vanguard 500 index fund uh with the ticker VOO. Both of these funds track the SP 500 uh as close as possible. They both carry the exact same fee. That fee is quite often uh expressed as the expense ratio. Uh in these two funds case, it's 0.03%, also known as three basis points, virtually free, dirt cheap. That is the fee that people focus to when evaluating what the fees of different funds are. They'll be looking at the expense ratio of each fund. This is about as cheap as things get. What's actually happened with those two ETFs? They had extremely similar results because they're doing the same thing. And let me be very clear, not all SP tracking uh ETFs weight the fund the same way. Some will weight them, or most, I should say, will weight them based on the size of each company's uh position within the index. Uh a larger company uh such as um Tesla or Amazon, they'll have a higher weighting than some of the lesser-known companies that are down on the bottom of the list and number 400. What these two funds have done uh over the last five years is that they've both returned 11.3%. A great return, especially if all your fees were only 0.03%, of course. Uh over the last one year, both funds had about a 33.5% return. It's been an extremely generous 12 months to compare that, of course. That's not usual. Um, but that is the uh particular case with these two exact ETFs. Both of these ETFs, the top 10 stocks, they make up 36.5% of the entire fund. So to try and make that relative to listeners, imagine you had uh$1 million ready to invest. That would mean that the advice is to go and put$365,000 in just 10 companies. That's a pretty big concentrated bet. That these 10 companies are gonna go well. Uh, those uh let's look at the top 10 stocks uh in previous years. If we go back 20 years and look at what was holding the top 10 position of uh the SP 500 20 years ago today, that answer would be uh number one, ExxonMobil, then General Electric, Microsoft, Citigroup, Bank of America, Royal Dutch Shell, BP, Johnson Johnson, Proctor and Gamble, and Pfizer. Only one of which is still in the top 10 today. Now, if we look at the average return of all of those 10 companies together over the last 10 years, there's been about 6.2%. What's more shocking behind that underperformance of 6.2% is there was only really one big winner, that'd be Microsoft. Microsoft was the only company within that top 10 that not only stayed in the top 10, but actually outperformed the average. Uh Microsoft over the last 20 years has done 15% return, where Moddow reminds you, the average of the index did about 11.3%. Several companies were complete duds. Um, GE and Citigroup dragged everything down. And most were just okay. You know, eight out of 10 of those are still in the index today. Now, why am I pointing this out? It brings me to my first point. If you are simply tracking an index, you are forced into buying and holding companies purely based on where they sit within this index. That means you would have need to uh hold all of those companies, uh, or eight out of ten of those companies, you would still need to be holding today. Even though they've gone uh down far from their position that they were 20 years ago, if you were in this fund, you had no option but to hold those on the way down. An index tracking fund has no flexibility to uh uh make changes. They invest uh due to a very strict mandate. I know listeners could say, well, yeah, but so be it. It's still made a very good return, a handsome 11.3%. Let me be extremely clear on this. I am not discouraging that uh uh taking this simple approach is not an excellent way of growing wealth. It's a very simple, very cost-effective uh way to become an equity investor. For do-it-yourself investors, I am not saying that this is a bad strategy whatsoever. I am, however, saying that when seeking a professional, often solutions can be a little bit smarter, a little bit more tactical, enhanced. And I'm gonna go start diving into some of the ways those can be enhanced or some of the pitfalls of the simple strategy. When investors are investing in one of these ETFs and looking at the expense ratio, that's not the only fee they're being charged. If they're buying through a platform such as Sherzy's or Hatch or Stake, there's quite often a foreign exchange fee at somewhere between 50 basis points and 100 basis points, or in other words, 0.5% or 1%, um, when converting New Zealand dollars to US dollars. There's also transaction fees for every time that you buy the fund. So if you're doing regular contributions uh to the uh an ETF like this, every single time you're putting money in, you're going to be charged some uh foreign exchange fees and you'll be exchanging uh charged some transaction fees as well. There's also buy-sell spreads. I don't think I'll go down that road just yet. Uh when we're talking about an S ⁇ P tracking fund, the spreads between stocks and buys and sells are very, very low because they're all very highly liquid stocks. They're heavily traded. Now, a very, very common hidden cost with taking this kind of approach that will never show up in a balance sheet. It'll never show up uh in a statement anywhere. It's the fact that the these ETFs cannot buy stocks unless they are on the SP 500 index. And they can only buy it relative to its size, uh, as mandated within the ETF itself. Those mandates can change. Some weight the uh megacaps higher, some weight the lower cap stocks. Uh there's different rules, and you you need to look into the details of exactly which ETF you're buying. If you're buying the uh ETF I mentioned, the VOO, um which is the Vanguard uh SP 500, you'll be buying the uh stocks uh completely uh relative to the size of the company within the index. Now, where this gets tricky is how does a company or a stock actually get added to the index? In order to uh join the SP 500, there's actually seven criteria that need to be met before they'll actually be announced to be put on the index. Those seven criteria are uh first and foremost are market capitalization. It must be a large cap company, which is technically between 18 to 20 billion. It changes from time just to be considered. Number two, it must be a US uh based company. It must have headquarters in the United States and the majority of its assets and revenue tied to the United States. There's also a profitability requirement, which is the third. Um so this is quite a big one, and I'll explain why in just a moment. But it must have a positive GAAP earnings uh over the most recent quarter, and the sum of the last four quarters must be positive. Criteria number four, it must be uh highly liquid. It's uh measured by trading volume relative to float. Uh number five, uh, it must have public float of at least 50% of shares, must be publicly available. Number six, it must be listed on a major US exchange, such as the New York Stock Exchange or the Nasdaq. Number seven, and this one, this is where it gets tricky and a bit discretionary. So it actually gets quite interesting. Um the it's it's decided by a committee, and the committee aims to maintain sector balance and reflect the overall US economy. And what that means is a company can meet all criteria and still not be added immediately. So why why am I explaining the criteria to get on this index? And what problem does that actually pose for index tracking fund investors? Well, let's look at an extreme example of something called front running. Tesla. When Tesla was actually added, finally added to the SP 500, it came in at position number six. It didn't meet all seven criteria until it had reached a point where it was the sixth largest company in the SP 500. That means when it entered, it entered with a weighting of about 1.6 to 1.7% of the entire index. It wasn't one 500th, it was 1.6 to 1.7%. This is very uncommon. Most new additions are uh small caps. Um Tesla was a top 10 on entry day. Now, what actually happened? So a company doesn't get added to the index the moment it meets all the criteria, it must be first announced by Standard and Poor's. They will make announcements, and typically the stock won't be added until five days after announced. So, what actually happened to Tesla once that announcement was made? Within two hours of Standard and Poors announcing that Tesla is going to be joining the SP 500, the stock jumped 13% and it continued to rise. Why? Well, the entire market knew that index funds must buy this stock. And they're not going to be buying it lightly either. It's coming in at number six. There's going to be a lot of buying pressure on this stock because these mandated indexes they have to buy it. They have no choice. So active fund managers, hedge managers, people looking for opportunity, knowing that a lot of money was going to pour into this stock, they were able to get in first. They had about five days to get in before the index funds had to pour their money in. Between November 16th and December 18th, Tesla rose nearly 60%. Active investors were buying ahead. Index funds had not yet bought. On the day that it finally uh on inclusion day, um, there was massive trading volume, one of the largest in history. There was 80 to 100 billion worth of stocks traded on that day. The price action was highly volatile. It closed near highs at the end of the day. But what happened after inclusion? Once all the active fund managers had realized a gain, they could sell them off. Now, in reality, all that really happened was the stock lost a bit of the momentum that was crazy leading up to inclusion day. Uh, in fact, there was a minor drawback. Why I'm calling this a hidden cost of uh buying uh uh SP 500 tracking ETF like this is everybody in that ETF bought Tesla at a much higher price than everybody that was able to get in earlier and buy earlier once the announcement was made. This cost is never going to show up on a balance sheet because really it's not a fee that you've paid. It's just a cost that you've incurred by not being able to have the flexibility to buy a few days earlier. Now, this is an extreme example, though. As I mentioned earlier, most companies joining the SP 500 do not come in in a top 10 position. In fact, most commonly when a company is added to the SP 500, it's added between number 250 to 400 or so. Tesla was a very rare anomaly. Why that anomaly uh meant so much is because of that weighting, there was so much higher uh buying pressure on that one particular stock. And whilst I'm saying that other companies come in at a far, far lower number and therefore a far, far lower weighting, um, i it that's not uncommon. But the what is extremely common is the exact same pattern. What happens is a company is announced, opportunist will buy that as soon as the announcement is made. Once all the index money has poured in, as it is mandated to do so, gains have been made, and active managers are free to sell when they want to and realize some gains, should they choose to. Okay. So that's only focusing on the positive when stocks are being added and experiencing growth and gains. What about stocks that aren't experiencing growth and gains, or even worse, being deleted from the SP 500? Plenty of funds that have more flexibility and uh less mandates on what they're able to do will participate in something called securities lending. What this is is uh uh essentially uh some active fund managers will participate in what's called shorting stocks. They're betting that the stock is going to go down. The only way they're able to um short a stock is they must borrow it from somebody that owns that stock. Now, if you have a a fund that owns many, many, many, many stocks, it's very well diversified, um, and uh they uh own every company in the SP 500. When a deletion comes up and a company is going to be deleted from the SP 500, or if there's just a stock that's not doing so well and uh a bit stagnant, short sellers might want to rent that stock uh from whoever owns it. When a deletion comes up, the demand for uh for renting the stock that's about to be deleted goes through the roof because uh active managers know that it's going to be kicked out of the SP 500, and therefore that means that every fund that's tracking the SP 500 will be forced to sell that stock. Therefore, they're making a pretty good bet that the stock's going to go down. When the owner of a stock chooses to rent that stock out to a short seller, they're able to charge a premium. Uh kind of uh like a rental fee for lending the stock out. So where they see an opportunity to do exactly that, they can rent the stock out. They haven't uh they don't own any less of the stock, they've just rented it out and charge some interest. Essentially charging a fee, no one is lending income. Funds like Dimensional, or DFA, it's better known as, that hold plenty and plenty of stocks, they'll be more than happy to um uh uh rent the stock out to some short sellers. They will need to borrow, they'll need to pay the rent, dimensional lends them the shares, earns the lending fee, and then takes the stock back once the job is done. Now, this is far more uh effective on stocks that are in strong demand. So when a deletion comes up, that means there's more demand on people wanting to rent it. That means they're able to charge a larger fee. However, when a stock is so highly traded and therefore so highly liquid, the premium they're able to charge is not so much. The more volatile the stock, uh typically, the uh well, more emerging markets, they'll they'll be able to charge higher fees. Where this is important and why this is being included in an episode, you know, essentially highlighting the hidden costs is this again won't show up on a balance sheet. It's it's not a fee that you have to pay by holding an SP tracking ETF. However, it is something that you are missing out on if you don't have the ability to do that. In reality, what does it really mean? It's not going to make or break a major, major difference. Uh in reality, the difference is between about two basis points to 20 basis points. So, in other words, 0.02 to 0.2%. Where this one gets a little bit tricky is not all fund managers pass that income generated from renting out stocks back into the fund. They don't have to. Uh the likes of Dimensional, they do. They put 100% of the income generated from that minus any fees that were incurred back into the fund. Um the Vanguard group, um, they return most, often 90% to investors, 90% or more. Um BlackRock, um, they do about roughly 60 to 70% to investors, and they they keep a larger cut for themselves. I just want to highlight again that typically the impact is 0.02 to about 0.2%. It can be much higher in small caps and hard to borrow stocks. When you start to add up uh a number of these missed opportunities, uh, or what I'm calling hidden costs, it can actually start to really change that original 0.03% expense ratio mentioned before. Okay, so I'm gonna get on to the uh the last point. And I've saved the best for last. This in my opinion is the biggest argument to the hidden cost of uh investing in an SP tracking fund alone. To answer this one, I'm gonna take you back to 1999. Let's say you had a million dollars to invest in 1999 and you decided to uh deploy this tactic and just bought the VOO fund mentioned earlier, the the exact same expense ratio. Well, let's actually look at What happened for the the the next 10 years, the year 2000, major market correction in the United States. We had the dot com bubble, it had burst, and it took seven years before uh the the uh US stock exchange had actually recovered from its previous high. The moment that it had recovered, the very next year was 2000 and s uh was 2008, the global financial crisis. That one hit hard. So let's put this into a dollar term. In 1999, you had a million dollars to invest. After your first two years of investing, you go to check your balance and it's down to 800,000. And that's assuming you hadn't taken anything out of it. If that's a hard pill to swallow, let's imagine another five years on, you're finally back to the million dollars that you started with, and then bang, 2008 hits. The global financial crisis is in effect, and now after eight years of investing with this simple strategy, you uh your balance is down to six hundred and thirty thousand and you still haven't taken a cent out of the fund. On that eighth year, someone came and asked you, What's your investment strategy? I I might want to copy you. Would you be so confident with that experience to say, Oh, I just invest in the SP 500, and I suggest you do too. Now, I I know there'll be listeners screaming, Yes, Tim, but you're looking at you're talking about uh extreme time periods and still relatively short time periods, and you're a hundred percent correct. Where I'm getting at with with this argument is did you really need to go on that emotional roller coaster? Would have you been able to stay on the roller coaster having experienced that? Was it absolutely necessary in order to get that 11.3%? Or was it really necessary to go on such a roller coaster? The the fact is, uh I took you back to 1999. We're we're in the year 2026. The thing is, we we just don't know what decade you're in until the decade's over. So how could we address this? What what I'm really getting at for any listener that hadn't already got ahead and guessed this, I'm talking about risk-adjusted returns. How global diversification could lead to the same outcome, but make the ride a heck of a lot smoother along the way? Why would that be important? Well, if I took a hundred investors that did exactly what I just proposed in 1999, how many of those investors do you think really would have stayed the course all the way through and until they actually managed to get that 11.3% return? Would some of them jump off the roller coaster, solidify those losses? Well, what about if they took a slightly different approach and used a little bit of global diversification? I'm gonna talk super broad numbers. I don't want to be nitpicked on this. You can in the comments if you wish to. That's up to you. But I I tried to make an example portfolio using very, very high-level data. 50% of the fund is sitting in the United States uh stocks in the SP 500. 30% was in developed international, so the MSCI world excluding US index. The last 20% was invested in emerging markets, so the MECI emerging markets. Over the exact same decade, instead of coming out with a 0% return, which you would have with an S ⁇ P 500 tracking fund. Sorry if I didn't make that clear earlier on. By the end of 2010, after 10 years of investing, the fund is now back to a million dollars. If it wasn't quite back to a million dollars, it was slightly less after 10 years of investing. Let's compare that to what it would have looked like with a little bit of very simple global diversification: 50% US, 30% developed international, 20% emerging markets. With that kind of diversification over the exact same time period, the globally diversified portfolio would have experienced somewhere between a 4% to 6% return. I'm not suggesting that global diversification always will get you higher returns. But what I can be very sure of is if history repeats itself, it would have got there in a far smoother ride than the extremely dramatic roller coaster that uh 2008's negative 37% would have had on your portfolio. Because might I remind you, the only way you got back to a million dollars in the non-diversified portfolio is only if you managed to stay on that roller coaster the entire time. You never look to seek an alternative, you never look to jump ship, you never look to change tactics at any point. That was the only way you got back to a million dollars. Okay, so I I hope I've helped answer some of the questions around why doesn't everybody just take this super simple approach? What are the hidden costs involved? Why aren't all advisors recommending this to every single one of their clients? I'm sure there's plenty more other arguments. And you know what? I would actually love to hear other people's thoughts on this. If you have an opinion that you want to share, if you have any questions, if you want to debate anything that I've shared today, please feel free to get in touch at podcast at foxplan. As for this week, that's us.