The Hidden Cost of Cheap ETFs

There’s a simple story most investors like to tell themselves:

“If I keep my costs low, I’m doing the smart thing.”

That narrative is so widespread that it rarely gets questioned. The industry built a $10 trillion ETF marketplace on the back of it. To be fair, the move away from high-fee, opaque mutual funds was long overdue.

But we’ve reached the point where cost is used as a proxy for quality. That’s become a bit of a problem.

Fee Compression Is No Longer A Differentiator

Let’s start with the basics: a few basis points in expense ratio won’t make or break most portfolios.

The difference between 0.03% and 0.06% on a $10,000 investment? $3 a year!

That’s noise compared to what really drives long-term outcomes: allocation, performance consistency and behavioral discipline.

The problem arises when fee sensitivity leads to fund selection that underperforms for structural reasons. A cheap ETF that tracks a broad benchmark, such as one tracking the Russell 2000, might contain a lot of dead weight. When markets get choppy, that dead weight shows up in your drawdowns and recovery timeline.

Cheap ETFs Often Come With Diversification Drift

Take the S&P 500. It’s not a static entity. It’s a living, breathing index. At different points in time, it gets overloaded in tech or underweights energy or concentrates in mega-caps. Buying a cheap S&P 500 ETF, such as the Vanguard S&P 500 ETF (VOO) or the SPDR Portfolio S&P 500 ETF (SPLG), might sound like the same thing. However, if you tilt slightly toward one with float-adjusted weighting or one that lags in reconstitution timing, you end up with real return gaps over time.

Now extend that to dividend ETFs, value ETFs or low-volatility products. The cheapest fund isn’t necessarily the most precise. It might rely on looser screens, backward-looking criteria or poor rebalancing mechanics. In trying to save 5 basis points, you may be sacrificing 100.

Sometimes Paying More Is The Smarter Choice

This isn’t an endorsement for active management or expensive boutique funds. It is a reminder though that low cost is not the same as high value. Some ETFs justify a higher fee because they:

• Use smarter weighting strategies (e.g., equal weight, revenue weight, fundamental screens)

• Have rules-based downside buffers or volatility overlays

• Include quality screens that reduce tail risk over time

When volatility returns, these structural differences show up in both performance and peace of mind.

Bottom Line

It’s time to stop treating ETF fees as a primary filter. For serious investors, cost is a component, not a compass. The better question is: What am I actually getting for what I’m paying?

Next week, we’ll explore a deeper issue: how ETFs despite all their benefits may be enabling poor investor behavior through over-accessibility and frictionless trading.

📣 Next Tuesday’s Post → “The ETF Boom Is Killing Investor Discipline”