Watch out for the hidden costs of ETFs

We're big fans of exchange-traded funds (ETFs). Not only can they help you gain broad exposure to a market or a sector, but their charges are much lower than actively managed funds (many of which are closet indexers').

However, even within the world of ETFs, you have to watch out for hidden charges. If keeping costs down is one of your goals (and it should be), then it's worth comparing different ETFs to see which one offers the most efficient way of tracking your chosen index.

That's not always as straightforward as it should be. Management charges, and the total expense ratio (the combination of management and admin costs), are usually easily available. But these are not the only potential costs you should be concerned about. ETF provider Lyxor points out that there are three other criteria that affect efficiency.

One is the liquidity spread' (sometimes known as the bid/ask spread). This is the gap between the buying and selling price of an ETF. Since you pay slightly more to buy an ETF than you would get if you immediately sold it, the bigger the spread, the higher the cost.

Most popular ETFs (such as those following the FTSE) are extremely liquid, with plenty of buyers and sellers, and so have low spreads. However, the more lightly-traded products tracking more obscure indices (such as emerging markets) often suffer from higher spreads. Also, even within sectors, you may well find that a more popular ETF offers tighter spreads than its rivals.

The next two costs are the tracking difference and the tracking error. These measure the extent to which the ETF actually follows the index it is supposed to track. The tracking difference is the absolute divergence, while the tracking error is the volatility of the tracking difference over time.

While divergence can lead to the fund beating the market by a small amount, most funds end up slightly underperforming. In any case, if you're buying the fund for a specific reason, it complicates matters tremendously if it behaves in an unexpected way.

Lyxor has combined all of these charges to produce an efficiency rating. This is expressed as the underperformance expected at the 5% level. So a fund with an efficiency rating of -0.5%, will lag the index by 0.5% or more five times out of 100. In simple terms, this means that the more sharply negative the rating, the less efficient it is.

In many cases the hidden charges aren't very big, with the fifth-most efficient S&P ETF having an efficiency of -0.16%. However, in other cases it is much bigger, with even the most efficient MSCI Emerging Markets ETF having a rating of -0.87%.

Of course, there are other risks associated with ETFs, over and above charges, which you should bear in mind when choosing any such product. For instance, while synthetic ETFs, which use swaps to mimic an index rather than holding actual shares, usually have lower tracking errors, they suffer from counterparty risk. This is the risk that the bank or institution that writes the swap could go bankrupt. In contrast, a physical ETF doesn't have this risk since it own the original shares.

To reduce this risk, synthetics are required to hold collateral equivalent to 90% of the value of the ETF. However, this collateral doesn't necessarily reflect the exact value of the index (for instance a FTSE ETF could be backed by blue-chip American shares). In the event of a counterparty going bust, this divergence might become significant.

Firms that do mainly synthetic ETFs, such as Lyxor, respond to this by arguing that many physical ETFs participate in share lending in an attempt to defray management costs. This has the potential to create complications if the borrower of the shares runs into problems. However, the risk is much lower, and physical ETFs are required to be very clear about this in their prospectus.