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The Costs Of Pooling
There are a variety of additional expenses associated with running a pooled account, both explicit and implicit. The explicit costs of pooled accounts include the costs of unitization, audit requirements, commissions, the bid/ask spread and other miscellaneous administrative expenses. The implicit costs of pooled accounts relate primarily to the impact of cash drag, which negatively impacts the performance of the pooled account.
The two types of transactions costs incurred by an ETF investor are the bid/ask spread and commissions. As discussed earlier, the average bid/ask spread for the Vanguard ETFs is 8 bps (or 4 bps each buy or sell). This 4 bps "fee" will be incurred each time an ETF is bought or sold. Commissions, similar to the bid/ask spread, are a cost paid each time an ETF is bought or sold, since unlike mutual funds, ETFs cannot be redeemed at NAV and must be purchased on the open market. While trade aggregation (through pooling) decreases commissions, even a commission as low as $.02 per share will reduce the net performance of an ETF-pooled account over time. Again, while these transaction costs may appear to be minor, the bid/ask spread and commissions represent a definite cost that must be considered when addressing the relative benefits of ETFs versus mutual funds for 401(k)s.
The costs associated with pooling vary between plan-level pooling and aggregate pooling (e.g., using a CIF). The costs associated with pooling ETFs at the plan level vary by provider; however, a reasonable current estimate would be $500 per plan ETF (e.g., if a plan wanted an all-ETF investment lineup consisting of 12 ETFs, the total cost would be $6,000). While additional expenses, such as an audit, are not necessary for plan-level pooling, such oversight is likely necessary to ensure that the unitization is being properly handled, especially for larger plans. Additional administrative and operational costs beyond the basic pooling fee may also be incurred.
The costs for pooling an ETF at the aggregate, or CIF level, are also going to vary by provider. The unitization costs associated with a CIF are typically not going to be much lower than 3 bps and can easily exceed 10 bps based on the size of the unitized account. A CIF must be audited at least once each 12-month period (in accordance with 12 CFR 9.18(b) (6)), which will typically cost at least $5,000. However, as the assets increase, so do the fees associated with the audit, since the risk of the auditor increases along with the assets. While an audit fee of $5,000 may seem insignificant, it represents a cost of 10 bps on a $5 million account, 1 bp on a $50 million account and 0.1 bp on a $500 million account. Every basis point is important when comparing the relative benefits of ETFs and indexed mutual funds, since the overall cost differences between the strategies are already relatively small.
The implicit costs associated with pooled accounts relate primarily to cash drag. Cash drag relates to the need for any pooled account, including mutual funds, to have funds available in order to meet the cash flow (i.e., redemption) needs of its investors. While cash drag is also a consideration for mutual funds, it is less so because the impact of cash drag is typically inversely related to pooled assets. The larger the account, the lower level of cash that must typically be held, and therefore the less the impact of cash drag on performance. Since mutual funds are investments that can be used in a variety of settings (e.g., foundations, individual accounts, IRAs, etc.), they have a much larger potential asset base than CIFs, which can only be used in retirement plans. Also, mutual funds are established savings vehicles that are relatively easy for participants to research (should they choose to do so); since CIFs are not publicly traded, it is more difficult to obtain information on them.
As an example of the impact of cash drag, if you assume a 4 percent cash return and a 10 percent market return, for each 1 percent cash position, the return of the CIF would be decreased by 6 bps. Therefore, a 2 percent cash position would lead to 12 bps of underperformance. If the market return increases to 15 percent and the cash return stays at 4 percent, the impact of cash drag increases to 11 bps for each 1 percent of cash in the account.
So what are the total costs of pooling likely to be? Well, the costs are going to vary based upon a variety of factors, but based on conservative assumptions, it’s going to cost at least 4 bps to purchase an ETF (assuming 3 bps for the bid/ask spread and 1 bp for commissions), and 10 bps for the ongoing management of an ETF (assuming 5 bps for the overall pooling/unitization and 5 bps of cash drag). While 4 bps and 10 bps for trading and ongoing management, respectively, may seem small, the overall cost differences between index mutual funds and ETFs for a number of scenarios are actually even smaller.
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