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I understand that different ETFs may cost different amounts of money per share, as you are buying a proportional amount of each company on the index, but why can two ETFs that cost roughly the same amount of money per share but have different expense ratios coexist i.e. why would someone be prepared to pay more for the same thing?

What kind of advantages can a more expensive ETF have over a cheaper one that tracks the same index?

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Other possibilities that might be at play (just hypothesizing here):

  • An ETF with fewer assets-under-management (AUM) may encounter less index tracking error over time since their positions in the component stocks will be smaller. Therefore, they may be able to execute rebalancing trades more efficiently in the market than a larger ETF.
  • A more expensive ETF may, nonetheless, be the more liquid ETF among similar funds. The higher liquidity may be attractive for people looking to execute a particular type of trading/investment strategy.
  • Some investors may have a preference for the different types of ownership structures used by different ETF sponsors. Not sure if this is still true, but when Vanguard launched their ETFs, I read somewhere that they used a patented method whereby the ETF shares were a unique class of interest tied to their mutual funds that track the same indices. I forget exactly why they did this, but I think it enabled them to keep their expenses lower than the competition and preserve their management structure whereby the funds are part owners of the management company (i.e., Vanguard itself).
  • Another example sort of related to the bullet above is that SPY is structured as a unit investment trust (UIT) unlike newer S&P 500 tracking ETFs, which are open-ended funds. The following is a quote from http://www.investmentnews.com/article/20141129/FREE/141129931/spy-the-etf-thats-challenging-vanguard-for-worlds-biggest-fund

    The most notable impact of SPY's different structure is that dividends can only be reinvested quarterly, whereas open-end funds can reinvest daily. Also, a UIT cannot lend out securities to short sellers and collect a fee. Such securities lending can bring a tiny bit of revenue that goes back into the fund and helps performance.

More from a SPDRS filing with the SEC regarding UITs (https://www.sec.gov/Archives/edgar/data/1222333/000119312514287007/d766507dfwp.htm)

The first ETFs were structured as Unit Investment Trusts (UIT) which are registered under the Investment Company Act of 1940. An example of a UIT is the SPDR S&P 500® ETF (SPY), the oldest, largest, and most traded ETF in the world. Other examples include SPDR S&P MidCap 400® ETF and SPDR Dow Jones Industrial Average ETF. The UIT structure requires the investment manager to attempt to fully replicate the underlying index by owning literally every security in the index, thereby limiting the expected tracking error. Another notable distinction of UITs surrounds dividend payments whereby any dividends that the fund receives typically cannot be reinvested in additional securities. Instead, the fund manager will generally hold the income in cash or a cash equivalent until the time at which the fund distributions are made. UITs are not permitted to partake in securities lending. UITs are also not allowed to hold futures, options, or swaps, and, as a result, are not subject to counterparty risk.

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If the management expense ratios are fairly similar, then one reason for the existence of different ETFs tracking the same index is that one can then do tax loss harvesting: when your position in one ETF is at a loss, you can sell that ETF, note that as a capital loss, and use the money from the sale to buy an equivalent ETF.

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    I highly doubt that this was a motivation for the creators of these ETFs. – Beanluc May 4 '18 at 23:29
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    @Beanluc: The question doesn't ask "Why were they created?" it asks "What kind of advantages?" This is a great answer to that question. – Ben Voigt May 5 '18 at 2:48
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    @BenVoigt: Yeah but the answer says "one reason for the existence [...] is [...]" which I think is the part being referred to. – Mehrdad May 5 '18 at 5:35
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    This kind of loss harvesting is called wash sale and some jurisdictions, including the US, have rules aimed at preventing this. (e.g. in the US it's defined as buying a substantially identical stock or securities within 30 days of the sale). – CodesInChaos May 5 '18 at 12:02
  • It actually is ambiguous in the US. Schwab says "The IRS has not provided firm guidance on exactly what "substantially identical" means for funds and ETFs. So it's best to assume, for instance, that selling an index mutual fund that tracks the S&P 500® Index and putting the proceeds into an ETF that tracks the same index could leave you at risk of having the transaction deemed as a wash sale, and therefore have the loss offset disallowed for tax purposes." – user71659 May 5 '18 at 16:10
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Because depending on what broker you buy through there may be other transaction costs for some materially similar ETFs.

  • To put it more plainly: in a Vanguard account, you can buy Vanguard funds commission-free, but in a Schwab account, you can't, but you can buy a similar Schwab fund comission-free. – Xiong Chiamiov May 5 '18 at 17:35
  • Why would you buy mutual funds through a broker? – jamesqf May 5 '18 at 17:58
  • @jamesqf Employer sponsored 401(k), for example. – user71659 May 5 '18 at 21:50
  • Are Schwab, vanguard, fidelity, and TD Ameritrade not brokers now? All have different lists of commission free funds (both plain mutual funds and ETFs). – quid May 5 '18 at 23:06
  • @quid: No, they're not brokers - at least when you buy their mutual funds directly from them. (They may have brokerage businesses too, of course.) Nor would an employer 401(k) count as a broker, it's a plan administrator. I mean the simple case where a person buys a mutual fund: why would you go through a broker and pay commission, when you can buy directly with no commission? – jamesqf May 7 '18 at 4:02
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I see two reasons. (There may be others.) First is not keeping all one's eggs in the same basket. Suppose the company with the lowest expense ratio happens to be run by another Bernie Madoff? Then you lose most of your money when he's caught/absconds to someplace without an extradition treaty.

Second is that many people have several sorts of funds. So if you have several funds with Company A, one of which is say an S&P 500 index with an expense ratio of 0.05. Is it really worth the trouble of switching if Company B has an expense ratio of 0.049 for its S&P 500 fund?

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Administrative costs include the fund manager's salary and costs such as record keeping, accounting, mailing prospectuses, customer service and maintaining a website). Though they'll vary, these are not likely to be vastly different from ETF to ETF unless it's a small ETF.

Trading costs can come into play when index components change. This should affect all similar index ETFs relatively equally. However, if there are large amounts of buying or selling of one ETF, it can trade at a premium or a discount to its holdings. To get the NAV back in line, Authorized Participants trade large blocks of fund shares and underlying securities with the ETF manager, arbitraging the two back toward parity. This drives up trading costs for the affected ETF. This hidden cost is lower for ETFs tracking larger indexes but higher for that involve a narrower sector.

Large indexes can have many components. For example, the Russell 2000. It's cost prohibitive for an ETF to duplicate all of the holdings so they build a representative portfolio with a sampling of stocks that best mimic the performance of the index. A sampling ETF will have a lower expense ratio than one that tries to duplicate identically. Conversely, an index like the S&P 500 is comprised of the largest and most liquid stocks sp there's full replication.

The short answer to why expense ratios vary is that it depends on different variables.

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When you have a 401k, the manager tends to offer a limited set of mutual funds for investment. If your manager is Vanguard, then those will tend to be Vanguard funds. Because these options are negotiated between the fund manager (e.g. Vanguard) and your employer, there is less pressure for the funds to be the lowest expense. The expense comes out of the employees' returns, not out of employer funds.

In the specific case of Vanguard, they are known for having low expense index funds. That is probably why employers choose them. But another employer might choose a different manager because the manager is cheaper to the employer or offers options that the employer wants in the 401k.

Combined with people who don't check expense ratios, these captive investors provide enough of a market to support the funds.

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why would someone be prepared to pay more for the same thing?

This is slightly like similar to the question "Why are there $6 white t-shirts and $25 white t-shirts?"

Because, well. Vanguard people will buy vanguard t-shirts, Schawb people are likely to buy Schwab t-shirts, JP Morgan...

Interactive Brokers has an ETF Replicator tool for investigating these, which shows you highly correlated ETFs and lets you compare their performance and rates. You can set it to notify you when you are looking at or buying an ETF that is substantially similar but has lower fees.

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