Microcap ETFs offer a streamlined approach for investors who want exposure to smaller companies. These ETFs hold onto companies and can save the potential investor hours of research, but the funds aren’t free. Built-in fee expenses silently trim capital. While ETF fees have fallen in recent years, it’s still important to know the amount and how it’s calculated.
Understanding the Operating Expense Ratio
ETFs use operating expense ratios to determine how much of an investment goes to the fund manager. With a $10,000 investment into an ETF with a 0.50% operating expense ratio, $50 will cover the manager’s salary and other expenses. This won’t show up on an investment account since ETFs handle them internally. If the assets in the ETF stay flat, that $10,000 position will be worth $9,950. In this example, the ETF’s assets would have to generate $51 in capital gains for an investor to make a $1 profit.
Active Funds Are More Expensive
Investors can choose between two funds: active and passive. An actively managed ETF makes more frequent adjustments or employs trading strategies in an effort to supplement long-term gains. Passively managed funds don’t require as much work after a manager does the initial research. Someone still oversees the ETF and looks for compelling microcap ideas, but it doesn’t involve as much work.
ETFs that mirror the Nasdaq demonstrate this trend. The passive QQQ ETF has a 0.20% expense ratio, while the actively managed QLYD has a 0.60% expense ratio. The actively managed fund incorporates covered calls to provide more cash flow. Even though QQQ has delivered better results over the past five years, investors with QLYD have paid more in ETF fees.
What Influences Microcap ETF Fees?
The operating expense ratio reveals the percentage an investor will pay each year. Looking at this ratio shows that QQQ is more affordable than QLYD. But how do ETF managers arrive at those percentages?
Any expenses associated with keeping the ETF operational will increase the firm’s costs. Those expenses then get passed onto investors through the operating expense ratio. This is why actively managed funds cost more than passive funds. Those active funds need more people to monitor the ETF’s performance and make quick decisions that align with the ETF’s objectives. In QLYD’s case, those covered call positions each result in options fees. While anyone can buy and sell stocks without worrying about fees, options trading fees are still around, and they will reduce a fund’s profits.
Administration and marketing are other expenses that can impact ETF fees. Depending on the type of assets, the fund manager may also incur a storage fee which gets passed onto the investors. Any expense reduces gains, but there are a few forces that can work in the investor’s favor.
An increase in net asset value (NAV) will weigh down the expense ratio. Appreciating assets minimize the expense ratio, but declining assets will produce the opposite effect. Although some expenses are variable, many of them are fixed. The fixed nature of many expenses explains why the operating expense ratio changes when net asset value rises and falls.
However, net asset value isn’t only a function of market performance. Operating expense ratios can decline even if the investments in the fund lose value. Capital from new and returning investors can offset market corrections and allow fund managers to set lower operating expense ratios.
Are Microcap ETF Fee Expenses Different from Other ETFs?
Microcap ETFs follow the same business model as broader ETFs. Asset appreciation and more contributions from investors minimize the operating expense ratio. However, microcap ETFs can get stuck with higher operating expense ratios if fewer investors pool resources into them. iShares ETFs demonstrate this trend.
The iShares ETF mirroring the Nasdaq 100 (CNDX) has an operating expense ratio of 0.36%. There is also an iShares ETF filled with microcap investments (IWC), but it comes with a 0.60% expense ratio. Bull markets help most ETFs, but they have an outsized impact on larger ETFs since dividends get reinvested, and most investors hold onto those funds. Larger funds may also have better insulation from incoming capital from new and current investors.
More affordable ETF options can be found by comparing brokerage firms and buying ETFs from the largest firms. When it comes to ETF fees, size matters, and there is money to be saved by going with household names that offer microcap ETFs.
An Alternative to Avoid the Operating Expense Ratio
Microcap ETFs streamline research and give exposure to smaller companies that align with specific criteria. Investors can find microcap ETFs that focus on value, growth, dividends, and other objectives. While it’s great to have choices, the operating expense ratio will trim profits.
For microcap exposure without the ETF fees, look at an ETF’s holdings as inspiration. ETF managers list their funds’ holdings and concentrations. An ETF manager’s confidence in a position can be assessed based on its weight in the portfolio. A manager feels more comfortable with an asset that has a 5% concentration than an asset with less than a 1% concentration in the fund.
Instead of paying the ETF fee, investors could cherry-pick from a list of investments and determine which ones belong in their portfolios. This not only avoids ETF fees, but provides more control over you’re the portfolio. This approach also involves more work, but those high ETF fees compound and minimize total gains. Investors who can secure ETFs with operating expense ratios below 0.20% may not see this extra work as worth the effort, but it’s an option to consider for anyone who wants to save on fees.
