Future Focus: How to tell a great ETF from a good one
Look below the surface to find value.
For years, investors have been told that lower fees are better. There is a good reason for this.
Morningstar’s research has consistently shown that fees are one of the strongest predictors of future fund success. Historically, lower-cost funds have a higher probability of outperforming their higher-cost peers over the long term.
Many investors are eagle-eyed with management fees, knowing that a few basis points here or there can result in a meaningful difference to outcomes. Focus on fees – they’re guaranteed. Performance is not.
Yet fees don’t tell the whole story. In recent conversations I’ve been having with fund managers they often mention something called implementation alpha.
The idea is simple. The management fee is only part of the story. There are several other ways a portfolio can be managed to improve efficiency, reduce costs and ultimately leave investors with better outcomes. It isn’t just what you buy, but how you own an asset.
The rise of implementation alpha
Professional investors can add value past the investment selection process. Implementation alpha is incremental value generated through efficient trading, tax management, securities lending, portfolio optimisation, cash management and disciplined execution.
Bryce Anderson, Senior Portfolio Manager at Morningstar Investment Management explains that the term is broad and can range from the decision to make the investment itself, to the tool used to implement that idea, to the explicit costs incurred in executing the exposure.
He explains ‘For example, if you’re trying to gain exposure to a specific equity market, is it best to use futures, an ETF, or a basket of securities? That decision is influenced by explicit costs, but also by factors like whether it’s a long-term position or whether you need the flexibility for liquidity management.’
Unlike traditional alpha, implementation alpha doesn’t come from finding the next great stock but instead from eliminating the frictions that quietly erode returns. That might not sound as exciting as stock picking, but in an era where investment fees are measured in basis points and markets have become increasingly efficient, reducing friction can be one of the most reliable ways to improve outcomes.
Why investors should care
Focusing exclusively on management fees can sometimes cause investors to miss the bigger picture. The reality is that the return investors receive is influenced by many factors beyond the headline fee.
A useful analogy is buying a house. The purchase price matters but so does stamp duty, insurance, maintenance, interest costs and eventual selling costs. The cheapest house isn’t always the cheapest house to own.
The same principle applies to ETFs. The management fee is the headline price. The true cost of ownership includes trading costs, tracking difference, tax outcomes, bid-ask spreads, securities lending, portfolio optimisation and portfolio fit.
This distinction becomes increasingly important as ETF fees continue to converge. When one ETF charges 0.05% and another charges 0.08%, the difference is easy to calculate. The harder question is whether implementation decisions create benefits that outweigh that fee difference.
Tracking difference: the metric investors often overlook
One of the most misunderstood concepts in ETF investing is the difference between tracking error and tracking difference. Tracking error measures how consistently an ETF follows its benchmark and tracking difference measures the actual gap between the ETF’s return and the benchmark’s return.
For investors looking at the impact of implementation alpha, tracking difference is often the more useful metric. Tracking difference captures the combined impact of management fees, trading costs, tax outcomes, securities lending revenue and portfolio implementation decisions.
An ETF charging 0.16% that trails its benchmark by only 0.12% may ultimately be delivering a better investor experience than a fund charging 0.04% but losing significantly more through implementation costs.
This is where implementation alpha becomes visible. It’s the difference between the fee investors see and the total cost investors actually pay.
How managers add value for investors
Many investors imagine passive investing as a largely automated process.
An index changes and the fund buys and sells securities. The reality is considerably more sophisticated.
Morningstar’s manager research teams conduct deep analysis into how funds operate. Their research reports highlight how some of the world’s largest index managers devote significant resources to implementation.
Vanguard, for example, uses a range of techniques designed to reduce tracking costs. Portfolio managers may delay certain trades around index rebalances to avoid unnecessary transaction costs. Cash holdings can be equitised through futures contracts to reduce cash drag. The firm also engages in securities lending, with revenue returned to investors to help offset costs.
BlackRock takes a different approach. Its Aladdin platform handles much of the portfolio management process, while a global trading network seeks efficient execution and liquidity across markets.
Dimensional’s approach has a core focus on implementation as a source of value. Rather than mechanically buying and selling securities whenever characteristics change, portfolio managers provide traders with flexibility to seek better execution opportunities, reduce turnover and minimise transaction costs.
The objective for all fund managers focused on implementation alpha is to capture as much of the market return as possible after costs.
All large ETF managers operate sophisticated trading desks that make dozens of daily, cost-saving decisions.
When an index contains more than 1,000 stocks, many holdings represent less than 0.01% of the portfolio. Trading every single line item to match benchmark weights precisely creates unnecessary transaction costs.
Instead, portfolio managers typically use optimisation techniques to balance two competing objectives: minimising transaction costs and maintaining low tracking error.
Every trade incurs brokerage, exchange fees, and market impact. An experienced trading desk can reduce these costs by:
- Netting trades internally
- Trading patiently rather than rushing to market
- Avoiding unnecessary turnover
- Optimising execution around index rebalances
The friction of implementation increases dramatically as we move away from highly liquid, simple markets into more complex asset classes. As shown in State Street’s transaction cost analysis (below), trading costs rise sharply alongside benchmark turnover and structural complexity. While investors can’t control these market frictions, they can choose fund managers with the scale, trading expertise and portfolio management capabilities to minimise their impact.
This matters most in less liquid areas of the market – such as small-cap equities, emerging markets and many fixed income sectors – where implementation decisions can have a much larger effect on returns than the headline management fee alone. In these areas, paying close attention to a fund’s historical tracking difference may tell you more about the value you’re receiving than simply comparing expense ratios.
The real difference implementation alpha can make
Implementation alpha is not unique to equities. In fixed income, transaction costs and liquidity can be even more punitive. However, large-scale bond ETFs can turn their size into an advantage.
I asked Hugh Lam, Investment Strategist at Betashares how their portfolio managers use implementation to create value for their investors. The Betashares Australian Investment Grade Corporate Bond ETF CRED has historically delivered a tracking difference outcome lower than its headline management fee without relying on active duration or credit bets. It achieves this through:
- New issue concessions: By participating directly in the primary market, the fund acquires bonds at favourable issue spreads before they enter the secondary market (where spreads typically tighten).
- Execution: During FY26, the fund added an estimated +5bps to performance simply through trade execution across multiple counterparties.
This isn’t unique to one fund. Across Betashares’ fixed income ETFs, the way the funds are managed has often helped reduce the impact of management fees, so returns have stayed closer to the benchmark.
How to find a fund that focuses on implementation alpha
There are a few ways to spot managers who are actively adding value to fund investors.
The first is looking at tracking difference. One simple way for investors to look at tracking difference is through Morningstar. Navigate to the ‘performance’ tab of the investment on www.morningstar.com.au. The graph shows the growth of $10,000 for the investment (NAV), the index and the category. The difference between the investment (NAV) and the index indicates tracking difference.
The second is the Product Disclosure Statement (PDS). Funds may have a headline investment fee, but the PDS will have to reflect a total fee that includes an estimate for extra costs incurred by the fund. Morningstar provides a Total Cost Ratio (TCR) which reflects an all-inclusive cost. You can find this on the respective ETF and fund pages on www.morningstar.com.au. A lower TCR is indicative of a fund reducing costs through implementation.
The Product Disclosure Statement (PDS) often lists the allowances within the fund that give space for the portfolio manager(s) to create implementation alpha.
A few examples include:
1. Securities Lending
When an ETF lends its underlying shares to approved borrowers (like short-sellers), it receives lending revenue. A reputable manager will require high-quality collateral to mitigate risk and return a major portion of this revenue directly to the fund, offsetting operating costs. For example, Vanguard (VGS) returns 100% of its net securities lending revenue to the fund, helping push its net tracking difference closer to the index.
2. Tax-aware portfolio management
Leakage can be minimised through flexibility to rebalance when stock’s characteristics drift (for example, a company growing out of a small-cap designation).
Standard global indices assume the maximum foreign withholding tax is deducted from dividends. An ETF focusing on reducing costs may utilise tax treaties to claim lower withholding tax rates. If these withholding tax savings exceed the fund’s operating costs, the ETF can actually outperform its benchmark.
Lastly, I’ve used examples earlier in this piece of analyst research. Morningstar’s research reports and ETF ratings consider implementation expertise when rating funds. Analysis often includes explanations of how managers generate value for fund investors through implementation.
Final thoughts
One recurring theme from my conversations with investment managers was that implementation often consists of dozens of tiny decisions rather than one transformative decision.
A trading desk may save a few basis points through more efficient execution. A securities lending program may recover a few basis points of costs. A tax-efficient structure may preserve a few basis points of return. A disciplined rebalancing process may avoid unnecessary turnover.
My lesson is to never stop at just looking at the headline cost of an ETF in consideration. Understand the value of the management cost and the role smart management plays in improving outcomes.
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