How They Mislead Us About With ETF Expenses

There is a great “truth” put out by the financial advisory community that with ETFs, expense ratios are the only thing that matters. Lower expenses mean investors earn a greater return. Following Vanguard, which earlier this year cut fees on 66 funds, Schwab recently announced fee reductions on four ETFs with $66 billion in assets.

With the announcement, Schwab noted: “With these fee reductions, all Schwab market-cap weighted index ETFs are now available for less than 10 basis points.” The linked article highlighted that the Schwab 1000 Index ETF (SCHK) had cut expenses from 5 basis points to just three basis points.

A basis point is one one-hundredth of a percentage point. One percent is 0.01 digitally, which makes a basis point 0.0001. You would likely never notice the difference in ETF returns that have expenses with a few basis points’ difference.

The real misinformation occurs when discussing income funds, ETFs that pay significant yields. The financial services industry emphasizes the importance of searching for the lowest expense ratios, implying that higher expenses reduce the net income or yields from ETFs.

I regularly have subscribers ask or complain about ETF expenses because they believe that if a fund is quoting a specific yield, the expense ratio reduces the yield that the investor earns. That is definitely not the case.

ETF yields quoted by the fund companies and on financial websites are yields net of expenses, and investors will earn what they see. Let’s look at an example…

The iShares Preferred and Income Securities ETF (PFF), with $13.6 billion in assets, is the largest ETF focused on preferred stocks. It is an index-tracking fund, which tracks the ICE Exchange-Listed Preferred & Hybrid Securities Index (USD). PFF has an expense ratio of 0.46% and a current yield of 6.68%.

The Virtus InfraCap U.S. Preferred Stock ETF (PFFA) is an actively managed preferred stock ETF. The fund managers at InfraCap select investments from the preferred stock universe to generate an attractive monthly yield and capitalize on market mispricings. PFFA has total expenses of 2.48%, of which 0.80% are management fees. PFFA utilizes a moderate amount of leverage, which accounts for the majority of the added expenses.

Following the lower-expenses-are-better theory, you might believe that PFF is a better choice for investing in preferred stocks. Here are its numbers”

• PFFA pays stable monthly dividends and has a current yield of 9.71%, compared to 6.68% for PFF.
• The PFFA dividend has increased in each of the last five years, a benefit of active management.

The five-year total return from PFF comes in at 17.17%. The share price has dropped by 11.8%, and the dividends have kept PFF barely above water.

Over the same period, PFFA returned 82.6%. The share price gained 15.4%. The active management of PFFA allowed the fund to avoid the dogs in an unmanaged index and focus on the better opportunities.

PFFA has been a portfolio recommendation in my Dividend Hunter service since November 2018. This fund provides investors with a stable, high-yield, and secure income stream.