Expense ratio, tracking difference and spread: the real cost of an ETF beyond the fee
When comparing two ETFs that follow the same index, the first thing people look at is the expense ratio. It is a useful figure, but it does not tell the whole story. There are other costs, and a measure, tracking difference, that shows what really happened to the return.
What the expense ratio is
The expense ratio is the annual percentage of management and operating costs deducted from the fund's assets. You do not pay it as a separate fee: it is reflected in the share price, day by day.
An expense ratio of 0.20% means that on $10,000 the annual cost is about $20. It is small, but it repeats every year and every dollar counts in a portfolio held for decades.
What the expense ratio does not include
- Internal trading costs of the fund, when buying and selling the securities in its portfolio.
- Taxes borne by the fund, such as withholding on foreign dividends.
- Securities-lending income, which can reduce the effective cost.
- The bid-ask spread you pay when you trade on the exchange.
- Your broker's commissions, covered in the guide to the cost of rotating.
Tracking difference and tracking error
Two different concepts that are often confused:
- Tracking difference: the gap between the ETF's return and the index's over a period. It says how much it fell behind (or got ahead) in total. This is what matters most to the investor.
- Tracking error: the volatility of that gap. It says how irregular the tracking was.
An ETF with a low expense ratio can have a worse tracking difference than a slightly more expensive one, if the second offsets costs with securities-lending income or more tax-efficient management.
A hypothetical example
Two ETFs follow the same index:
| ETF A | ETF B | |
|---|---|---|
| Expense ratio | 0.12% | 0.20% |
| Historical annual tracking difference | −0.25% | −0.10% |
A looks cheaper by expense ratio, but B has in practice returned closer to the index. The figures are invented to illustrate the reasoning; always check the real data for each product on its page and fact sheet.
The spread when trading
The gap between the buying and selling price in the market is a cost paid every time you trade. In a thinly traded ETF it can exceed several years of expense ratio. The more you rotate, the more it weighs. Trade during liquid hours and prefer funds with volume.
How to compare them
- Note the ticker and distribution policy.
- Look at the expense ratio and the fund's size.
- Review several years of tracking difference on the provider's site or fact sheet.
- Check the typical spread at your broker.
- Check the trading currency.
If your strategy rotates every month, the spread and the per-order cost weigh more than a few basis points of expense ratio. See also how much capital you need.
This guide is informational and does not recommend any particular product.
Frequently asked questions
Is the expense ratio charged separately?
No. It is deducted continuously from the fund's value, which is why you see no charge on your account.
Is the ETF with the lowest expense ratio always better?
Not necessarily. Tracking difference, size, spread and structure also matter.
Where do I find tracking difference?
On the provider's fact sheet or product page, and on some ETF comparison sites.