Considering The Total Cost Of ETF Investing

by on September 23, 2010 | Updated December 21, 2012 | ETFs Mentioned:

The surge in ETF assets over the past several years has been driven by a number of factors, as investors have embraced the enhanced liquidity and tax efficiency these vehicles offer relative to traditional mutual funds and the improved diversification relative to individual stocks and bonds. But a big driver of the growth in ETF assets is related to costs, as the vast majority of exchange-traded products are considerably cheaper than traditional actively-managed mutual funds. With some ETFs now charging expense ratios as low as four basis points (including SCHB and SCHX) and the average fee on a mutual fund in the neighborhood of 1.4%, the impact of compounding costs for long-term investors is significant [see 101 ETF Lessons Every Financial Advisor Should Learn].

When praising the cost efficiency of ETFs, most investors focus on the component mentioned in the paragraph above: the expense ratio. That’s primarily because this metric allows for simple comparison between an ETF and any mutual fund alternative, as well as between ETFs. Moreover, much has been made in recent months over the escalation of “price wars” in the ETF industry–referring to the introduction of several low-cost ETF options and reductions of the expense ratios on existing products.

But in reality the expense ratio is only one element of the total cost of investing with ETFs; computing a more accurate and complete cost of ETF investing requires consideration of both additional explicit costs and fees that may be incurred during the trading process [see The Complete List Of The Cheapest ETFs].

Commissions

When considering the elements that affect portfolio returns, many investors overlook the impact that trading commissions can have on the bottom line. Because trading fees are generally measured in absolute dollar terms, the effective percentage this cost component represents can vary significantly. For those investing significant amounts of money with very little turnover, the impact of commissions can be minimal. But for investors using a more active approach, the costs can add up in a hurry [see also Cheapskate Portfolio].

For example, consider an investor with a $100,000 portfolio who pays $10 to execute every trade. If that investor makes a trade monthly–one buy and one sell order–the annual cost can exceed $200, effectively adding another 25 basis points to the total expense figure.

Fortunately for ETF investors, there are several options for avoiding trading commissions altogether. Schwab and Vanguard offer commission free ETF trading to their brokerage clients (on their respective lines of ETFs) and iShares has partnered with Fidelity to offer free ETF trading on 30 of the most popular iShares ETFs.

Bid-Ask Spreads

Another element of the total cost picture that must be considered isn’t as explicit as expense ratios and commission fees, but can add up rather quickly. Unlike mutual funds, which can be bought from and sold to the issuer at NAV, ETFs are traded between market participants at whatever price clears the market. And while there are arbitrage mechanisms in place to ensure that the market price of an ETF does not deviate significantly from NAV, it is possible–and somewhat common–for trades to be executed at a premium or discount to NAV. Investors buying in at a premium can put themselves in an early hole, just as those closing out a position at a discount to NAV can shortchange themselves on some returns. There are, of course, too sides to that coin–deviations from NAV can work in favor of investors as well [for more ETF news and analysis subscribe to our free newsletter].

Consider an investor who buys 100,000 shares of an ETF at $100.05 when the NAV is an even $100 and closes out the position at $109.95 after the NAV has climbed to $110. While the value of the ETF rose 10%, the bottom line return to the investor–before considering commissions–was about 10 basis points lower. Depending on the holding period on that investment, the bid-ask spread component of the expense equation could dwarf the expense ratio component.

One common misconception surrounding ETFs is that products with low average daily trading volumes are illiquid, and that investors will incur potentially significant costs in establishing or closing our positions. In reality, the arbitrage mechanisms built into ETFs provide for “spontaneous liquidity” that can allow investors to trade big positions in thinly-traded ETFs at or very near to NAV. That isn’t to say that ETFs are fool-proof–there is plenty of examples of investors getting burned by market orders. But there are a lot of tools available to minimize the bid-ask spread component of the cost equation, including limit orders and alternative liquidity providers [see our ETF Thought Leadership Center].

Advanced Cost Considerations

For certain ETFs, there are other more advanced cost components that must be taken into account. Products that utilize derivatives to establish exposure–such as leveraged ETFs and futures-based commodity products–often maintain cash balances on which interest can be earned. The higher the yield earned by uninvested cash held by leveraged and commodity ETFs, the larger the offset to the expense ratio charged by the fund and the lower the actual overall cost. The issuers of leveraged ETFs pride themselves on their ability to offer competitive yields on uninvested cash, understanding that doing so can have a material impact on the bottom line return [see Seven Tips To Keep Your ETF Investing Expenses Low].

ETF expenses are often simplified into just expense ratios–and this metric is a great place to start when considering the cost efficiency of a potential investment. But it’s ultimately only one piece of the puzzle, and can sometimes be a misleading indicator of actual economic expense.

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Disclosure: No positions at time of writing.