A Look at SSGA's ETF Revamp

A major event happened in the ETF space last week. State Street drastically lowered the expense ratio on 15 of its core products, to the point where its rebranded SPDR Portfolio funds are competitive again, after years of anemic inflows. SSGA partnered with TD Ameritrade to push its revamped funds onto TD’s no-transaction-fee platform.

TD Ameritrade upped the ante by removing dozens of similar iShares and Vanguard products from its no-transaction-fee platform—slapping a fee on something that had been free. Advisors who had built their businesses around the old offering set are losing their minds.    

The price tag that comes with fund expenses and trading commissions is highly visible. We all know that free is best, cheap is next, and expensive is toxic. But sometimes what everyone knows doesn’t tell the whole story.  The re-launch of the SPDR Portfolio suite might just be one of those times: a moment when ETF due diligence matters.

ETF costs do not end with the expense ratio. Even for ETFs with high asset bases, decent trading volumes, and broad, vanilla exposure, investors have to contend with tracking difference and trading costs. When investors or their advisors ignore these, someone is bound to pay the price.

Costs have two main components: tracking difference—which is the performance gap between the fund and its underlying index—and trading costs. The relative importance of each depends on the length of the holding period. Long-term buy-and-hold investors should pay close attention to tracking difference; frequent traders can afford to downplay tracking difference in favor of spreads and market impact.

We can hone in on the effects of tracking difference and trading costs when we look at seven sets of ETFs from competing issuers that track identical indexes. This accounts for half of the SSGA revamped funds. (Well, almost. In November, SSGA will be dropping the Russell 1000, 2000, and 3000 in favor of homegrown indexes. The new indexes should be extraordinarily similar).

The nice thing about looking at ETFs that offer identical index exposure is that we can focus on pure operational due diligence—costs and risks that arise from fund management and on the trading floor.  Costs can eat away at returns; risks can do far worse. There’s nothing like a flat out loss, such as an ETN default, for making an investor feel burned.  Nobody likes it when issuers close a fund they hold, either.  Since none of these direct competitors harbors any blowout risk, we can look to cost as the key differentiator.

Most investors have to watch both tracking difference and trading costs. FactSet ETF Analytics has designed a total cost of ownership metric (TACO) that combines the two, using a one-year holding period. It’s quite instructive to compare the TACO with the expense ratio. The TACO calculations below use re-stated median tracking difference results, to account for the recent expense ratio changes, and median daily average spreads. Here’s what TACO vs. Expense Ratio looks like for the seven sets of direct competitors, as of October 20, 2017:

SSGA’s new rock-bottom expense ratios make it the cost leader (or tied) in each of these seven matchups. But SSGA wins on TACO in four cases, leaving the other three to BlackRock and Vanguard. Frequent traders, you’ve been warned.

Here's how SPDR Portfolio funds compare on dollar volumes and spreads over the 45 trading days through October 20.

BlackRock clearly dominates the field for these direct competitors, in terms of assets, trading volume, and 0.01% spreads. 

State Street might be closing the gap.  Since the re-vamp announcement, SPDR Portfolio spreads have tightened and volumes have increased, compared to their post-Labor Day averages.

Should the increased volumes and tightening spreads hold, the SPDR Portfolio TACO will drop, making these funds competitive. Even today the buy-and-hold crowd—the ones who should be willing to absorb a bit of additional trading cost in exchange for better long-term operating efficiency—might want to take a serious look at the revamped SPDR Portfolio funds, focusing on long-term holding costs and operational risks. 

Operational-risk wise, all of the direct competitors in these segments have a clean bill of health, plus a track record of avoiding making capital gains distributions (except AGG). Investors can rest assured that none of these funds will likely close, default, or fail to file annual reports. Cost wise, the name of the game here is tracking difference (the gap between expected returns, as delivered by the fund’s underlying index) and actual returns (the fund’s net asset value, with distributions reinvested). It’s not just the magnitude of the gap, but also its variability that matters. After all, nobody wants to be the unlucky investor who buys a fund at its peak vs. its underlying index, only to sell it at a relative low. 

At FactSet ETF Analytics, we measure tracking difference over a rolling series of 12-month windows. We wind up with 252 12-month return gap values, one for each trading day in the calendar year. From that set, we cull the median, and the two biggest outliers, one on the upside and one on the downside. The median gives a pretty good picture of the fund’s expected behavior, while the outliers show us the best/worst case scenarios and define the range of investors’ experience.

Adjusting for the new, lower expense ratios, we can expect the revamped SPDR Portfolio funds to offer the best median tracking difference compared to their direct competitor tracking the Russell 1000/2000/3000 suite and the S&P 500 growth and value indexes. Yet we can expect Vanguard to continue dominating in bond funds tracking the Bloomberg Barclays Aggregate Bond and 10+ year Corporate Bond indexes. (Note that Vanguard’s BND tracks a float-adjusted version of the Agg.)

But things fall apart for the revamped SPDR funds when it comes to the tracking difference range.  These funds have historically delivered excess variability in tracking, especially compared to their competitors. This will still be the case even with the new expense ratios unless SSGA changes its portfolio construction methodology.

In markets where liquidity can be tight, SSGA often optimizes portfolios, sometimes quite heavily. Optimization means that the portfolio holds some, but not all, of the securities in its underlying index. It’s the opposite of full replication. Optimization can lead to tracking error when the portfolio securities don’t fully reflect market activity.

The chart below shows the replication percent for 10 of the 15 revamped SSGA funds and their competitors.

 * SPEM, IEMG, VWO, SCHE

** SPDW, IEFA, VEA, SCHF

*** SPMD, VXF

SSGA has optimized heavily in developed markets ex-U.S., emerging markets, and the U.S. investment-grade bond market, and moderately in U.S. small and mid-caps. While these markets can be tough liquidity-wise, SSGA’s competitors have managed to achieve near-complete replication in most of them. 

At this time, the newly revamped SPDR Portfolio funds have much lower asset bases than their competitors. It’s entirely possible that SSGA will be able to increase the replication percentage in challenging markets if the fee cut attracts new assets. This is precisely what happened with iShares MSCI Emerging Markets (EEM-US) as it grew. But for now, investors face some cost uncertainty because of the tracking difference that grows alongside optimization.

Anyone who is seriously considering a switch to one of the rebranded, newly cheap SPDR Portfolio funds risks losing out—on the trading floor and in the portfolio manager’s office. The bet may well pay off, especially if assets flow in and push volumes up, spreads down, replication higher, and tracking tighter in their wake.   Today, with relatively high TACOs driven by trading costs and notable tracking risk generated by optimization, this is a bet, not a certainty.  Whatever you do, don’t just look at the expense ratio. That could be tragically short-sighted. There’s no substitute for in-depth, bottom-up ETF due diligence.