Why ETF Expense Ratios May Be Hidden by Tracking Effects
Summary
The document explores why an ETF’s price relative to its benchmark may rise even though daily expense deductions should gradually reduce fund value. It explains that comparing market prices with an index can obscure small fee effects because of short-term variation, dividend treatment, and benchmark choice. For example, the discussion distinguishes price indexes from total-return indexes and notes that VOO and IVV target a total-return benchmark while SPY targets a price index.
Other influences include cash held for fund flows, derivatives used to manage cash exposure, and securities-lending income. Lending revenue can offset some management costs, while cash holdings can create performance drag. The answers recommend examining ETF net asset value and matching the benchmark’s return convention when assessing tracking. The explanations are plausible mechanisms, not a definitive attribution of the observed increase; the document provides an illustrative NAV comparison and reported lending revenue, but does not establish which factor caused the original pattern.
Key ideas
- ETF market prices and benchmark index levels may not be directly comparable because their return conventions can differ.
- Small daily management fees can be difficult to distinguish from fluctuations in NAV and price.
- Cash balances can create tracking drag, while futures may help manage exposure to cash flows.
- Securities-lending revenue may offset some ETF expenses.
- Benchmark selection and total-return treatment affect conclusions about ETF tracking.
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Full text
# Expense ratio in ETF price # Expense ratio in ETF price I am examining the relationship between the price of an ETF and the index it is tracking (in this particular example, the Vanguard S&P 500 ETF (VOO) and the S&P 500 index). I can see the expected 3-month cyclic trend due to the accumulated dividends in the ETF, however, I would also expect to see the effect of the expense ratio in the long-term. As far as I know, the expense ratio is built into the price of the ETF, thus we should be able to see that the price of the ETF is slowly decreasing in relation to the price of the index (I call this relationship the 'multiplier' on the graph - VOO price divided S&P500 price). On the contrary, what I can see is a small increase in the multiplier. Does anyone have an idea why this could be? ## Answer by demully (score 1, accepted) https://quant.stackexchange.com/a/47310 This is a very good question, and I don't mean that in the usual academic platitude sense! Imagine you or I wanted to replicate VOO ourselves. To manage the liquidity of inflows and of potential outflows, we'd need to run a few percent of NAV in cash. Which would mean our stock portfolio would have a beta of slightly less than 1. There "should" then be some market noise in the ratio/spread above, which there isn't. The absence of said tells you that the portfolio is not just cash + stock, which means supplementary derivatives overlays have to exist. The cash problem is easy to solve with futures. It is possible for dividend surprises to create different outcomes between holding the stock and holding cash plus future. However, it's leftfield as a source of returns... and assuming it would suggest that the no-arb pricing of futures (let alone options) had structurally failed. I suspect that VOO et al. do use futures to manage their tracking error from cash; but it's hard to imagine how this creates the anomaly you highlight. A more realistic scenario is one where the trackers lends their stock to shorters. The shorters know that the trackers will always be the most reliable and predictable holders, so potential lenders, of any stock. The problem is that the shorts, ie the stock-borrowers, are far from riskless. There is a credit spread in the funding cost of the stock-borrow. I suspect this, being in excess of the TER of VOO, is what allows the NAV to hold up with the underlying index in your example shown. very best, great question. ## Answer by JoshK (score 1) https://quant.stackexchange.com/a/47298 you need to look at the correct data sources. SPY and VOO both charge management fees. These fees will decrease the value of the fund and they are charged every day. The fees are small enough that you will not see them clearly versus the fluctuation from NAV. Let's do this with VOO: Look on Bloomberg at the ticker "VOONV Index" for the actual Net Asset Value. That comes up with a value for Aug-22-2019 of 268.43. The primary close for VOO is found under "VOO UP Equity". That value is 268.46. Right there you can see how the noise starts to filter in. Also, notice that the NAV only has two digits of precision. That's how Vanguard does it - they don't let you see more detail then that. Now, to make it a little more fun, ETFs are actively managed trusts. That means they have cash flows from other activities. Securities lending is the most common one. iShares is a little more clear than the other trusts in documenting what goes on behind the scenes. If you look at the latest IVV annual report it looks like they get about one basis point of securities lending revenue. It's not much, but neither is the expense ratio - so they can offset each-other to a degree. Also - ETFs hold some measure of cash as they go through their lifecycles. Some, like IVV try to minimize the cash to a basis point. Others, like SPY, can collect quite a bit of cash. This cash drag will again impact your performance vs the pure underlying index. Lastly - what SP Index are you using for benchmarking ? The SPX ? SPTR? You meed to make sure you are comparing apples to apples. SPY targets SPX and VOO/IVV target SPTR. ** Editing to add a chart. Below is IVV NAV vs SPTR from the last IVV dividend. You can see a very slight outperformance of the index because of the management fee. I hope that helps!
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