• This article explains why cost efficiency matters when analyzing investment vehicles and how to assess it.
• The information is aimed at advisors who want to optimize costs when distributing and building investment strategies for their clients.
• FlexFunds offers an asset securitization program to create ETPs in a cost-efficient way. For more information, feel free to contact our experts.

In the world of wealth management, costs are one of the few factors that can be directly controlled and, at the same time, have a significant impact on long-term results.

However, evaluating the efficiency of an investment vehicle goes well beyond comparing management fees or stated expenses.

Why cost efficiency is key in advised portfolios

What separates an efficient strategy from a seemingly similar one may be the total cost the investor faces over time, since gross returns can look alike.

For sophisticated clients, assessing costs is no longer limited to looking at a management fee or an expense ratio. The discussion has shifted toward the concept of Total Cost of Ownership (TCO), a metric that incorporates both visible costs and those that remain hidden within the operating structure of each vehicle.

From the advisor’s perspective, justifying an asset allocation requires showing that each instrument adds net value after costs.

This is especially important in large portfolios, where seemingly small differences of a few basis points can translate into thousands or even millions of dollars of cumulative impact over the long term.

Components of total cost in an investment vehicle

For a rigorous comparison across alternatives, it is necessary to distinguish between explicit and implicit costs:

Explicit costs

These are easily identifiable in the product documentation:

• Maintenance fee
• Expense ratio (ER), Total Expense Ratio (TER), or other vehicle cost indicators
• Custody fees
• Structuring fees
• Advisory or distribution platform costs

These expenses are usually reflected in the vehicle’s value, its NAV, or the product documentation, and are relatively easy to compare.

Implicit costs

These are harder to detect, but often have a greater impact on final performance:

• Bid-ask spread
• Transaction costs
• Market impact
• Tracking error
• Tracking difference
• Tax costs
• Liquidity costs
• Rebalancing costs

For this reason, evaluating only stated fees can lead to erroneous conclusions about which alternative is truly more efficient.

Comparison across vehicles

Cost efficiency varies significantly depending on the type of vehicle used:

Conventional mutual funds

Active funds usually carry higher management expenses due to the costs associated with professional management, research, and portfolio turnover.

Although they can justify these costs through alpha generation, the challenge lies in demonstrating consistently superior returns after fees.

ETFs

ETFs generally offer lower operating costs thanks to more efficient structures and, in many cases, passive management. However, the analysis should not stop at the TER.

Aspects such as liquidity, trading spread, and index replication quality can significantly alter the effective cost of the investment.

For example, two ETFs that track the same index may show similar stated costs, yet present relevant differences in tracking error or in the spreads paid during trading.

Structured and alternative vehicles

Private funds, credit structures, real asset vehicles, or alternative strategies tend to incorporate additional layers of costs:

• Performance fees
• Legal costs
• Structuring expenses
• Lower liquidity
• Valuation costs

Although these solutions can offer diversification benefits or access to specific risk premia, they require a deeper assessment of expected net-of-cost returns.

Impact of costs on risk-adjusted performance

One of the most frequent mistakes is analyzing costs in isolation, without relating them to risk-adjusted performance.

A more expensive vehicle is not necessarily less efficient if it manages to:

• Reduce volatility
• Improve diversification
• Reduce drawdowns
• Increase the Sharpe ratio
• Access uncorrelated sources of return

Conversely, a seemingly inexpensive option can end up being less efficient if it presents liquidity problems, larger deviations from the benchmark, or high transaction costs.

The key is to assess how much net return each basis point of assumed cost generates. This approach makes it possible to measure the true productivity of invested capital.

In addition, the effect of costs is cumulative. Annual differences that seem marginal can significantly erode wealth when observed over horizons of ten, twenty, or thirty years, due to the impact of compounding.

Best practices for optimizing portfolio efficiency

Advisors can improve the cost efficiency of their portfolios by applying a systematic assessment methodology.

First, it is advisable to use the concept of total cost of ownership instead of limiting the analysis to visible fees. This involves incorporating spreads, taxes, tracking error, and operating costs into the analysis. It is also worth evaluating the vehicle’s operational efficiency, including custody processes, NAV calculation, reporting, administration, and ease of distribution.

Additionally, it is recommended to compare vehicles that fulfill equivalent functions within the portfolio. A passive ETF should be compared with alternatives that pursue similar objectives, whereas an active strategy should be assessed on its ability to generate net added value.

It is also essential to analyze the real liquidity of the instrument, especially in specialized segments where the cost of entry and exit can far exceed the difference in stated fees.

Likewise, the assessment should always be carried out based on the client’s objectives. The cheapest alternative is rarely automatically the best.

True efficiency occurs when the cost assumed translates into a tangible improvement in risk-adjusted performance and consistently contributes to the portfolio’s strategic objectives.

Remember that at FlexFunds we develop ETPs through an asset securitization program in a cost-efficient way. For more information, feel free to contact our team of specialists.

Sources:

• https://www.etf.com/sections/news/what-etfs-really-cost 
• https://www.advisorpedia.com/markets/the-total-cost-of-etf-ownership-an-important-but-complex-calculation/
• https://www.justetf.com/en/news/etf/cost-of-etfs-total-expense-ratio-ter-vs-total-cost-of-ownership-tco.html
• https://www.pfolio.io/academy/etf-total-expense-ratio
• https://www.investopedia.com/what-clients-need-to-know-about-etf-costs-and-fees-11770886