How important is the expense ratio of an ETF?

According to US Securities and Exchange Commission, the expense ratio of a stock or a fund is the total percentage of fund assets used for administrative, management, advertising, and all other expenses. An expense ratio of 0.4% per annum means that each year the investor is charged $4 for every $1000 invested (more on this calculation below). It is important to note that the expense ratio does not include sales loads or brokerage commissions. Morningstar has a great article that goes into details of expense ratio; you can find it here.

In case of ETFs, the expense ratio is deducted from the portfolio; so it affects the performance of the ETF very slightly (the annual expense ratio is baked into daily NAV (net asset value) calculation). In other words, you will not be charged the expense ratio upfront; the fund management deducts the amount from the ETF performance. Suppose you own two S&P 500 index ETFs with 0.05 and 0.09 expense ratio. If S&P 500 returns 10% that year, your first ETF performance would be 9.95% and the second one would be 9.91% (assuming both ETFs perform exactly like the underlying index). However, because ETFs are traded on the market everyday, your final performance depends on how much you sold your ETF (yes, traders can influence even the index ETFs). 

Is expense ratio the only thing that matters? 

When you are choosing your ETF, you have to look under the hood and see how that ETF is structured. SPY and VOO, for example are both S&P 500 index ETFs, but they have some differences when it comes to dividends and derivatives market. SPY is a Unit Investment Trust (UIT), so it is legally not allowed to reinvest the dividend it collects from the underlying companies. It should keep it in cash and pay out to ETF shareholders. VOO on the other hand can reinvest those dividends in stocks and options until the payout day for a slight performance boost. In a bull market VOO can slightly outperform SPY, but in a bear market it lags behind SPY that kept those dividends in cash (because the reinvestment loses value too).    

The bottom line is, expense ratio among ETFs that have similar holdings are not going to make that much of a difference, but if you are deciding whether to put your money in an ETF or a mutual fund with fees more than 2%, then if that mutual fund matches the market performance (which most of them will not, more on that topic later), you are losing 2% in fees compared to less than a percent in an ETF.  

Disclosure: At the time of this publication I have no position in any ETFs mentioned. This publication is NOT intended as financial advice. Published statements are opinions only.