Exchange-traded funds (ETFs) have exploded in popularity over the past ten years, creating fierce competition among fund issuers. The escalating fee war has resulted in much lower expense ratios across different fund classes, giving investors more cost certainty when holding ETFs.
However, expense ratios only tell one part of the story. To determine the true cost of your ETF portfolio, you must evaluate other expenses that might not be so apparent at first glance.
Evaluating an ETF’s True Cost
How much does it actually cost to own an ETF? The answer might surprise you.
There are four direct costs associated with ETFs: expense ratio, commissions, premiums/discounts and taxes. Accompanying these are the indirect costs, including tracking error and liquidity constraints (i.e., bid/ask spread).
The expense ratio is the most obvious direct cost associated with ETF investing. It represents the portion of your investment that goes towards your fund’s management fees, which are incurred annually. For this reason, ETFs with lower expense ratios are seen as advantageous.
Examples of such funds include the iShares Core S&P Total U.S. Stock Market ETF (ITOT ) and Schwab U.S. Large-Cap ETF (SCHX ).
Commissions are the fees you pay your broker to buy and sell ETFs. They are similar to the fees you pay to buy and sell stocks. The good news is commissions have declined sharply thanks to competitive forces. This has led to the rise of the commission-free ETF. Questrade and TD Ameritrade, among others, offer commission-free ETFs.
Examples of commission-free funds include the iShares Edge Multifactor Global ETF (ACWF ) and the WisdomTree Negative Duration U.S. Aggregate Bond Fund (AGND ).
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ETFs sometimes trade at a premium or discount, which can often mean additional costs. For example, if you buy an ETF at a premium and then sell it at a discount, you lose money. In terms of ETF investing, premiums and discounts are understood within the context of the net asset value (NAV), which represents the sum of a fund’s assets minus liabilities, divided by the total number of shares outstanding. If a fund doesn’t trade close to its NAV, there may be issues with its creation/redemption strategy.
The total cost of ETF ownership cannot be divorced from the tax implications of investing. ETF portfolios that realize capital gains will be subject to capital gains taxes. ETFs that distribute dividends also have more immediate tax implications whereas non-dividend funds are taxed only when shares are sold. Holding ETFs in a tax-exempt retirement account is a good way of lowering expenses over the long term.
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A fund’s tracking error is another important consideration for evaluating an ETF’s total cost of ownership. Since passive ETFs are designed to track the performance of their underlying indexes, investors should consider funds with a median tracking difference that is close to the expense ratio. One of the most popular ETFs with a low tracking error is the iShares Core S&P 500 ETF (IVV ). In other words, it closely tracks its benchmark, the S&P 500 Index.
When it comes to buying and selling ETFs, liquidity constraints become apparent in the bid/ask spread. This is the difference between the price a buyer is willing to pay for shares and the price at which the seller will offload it. Trading volume and liquidity have a direct influence on the bid/ask spread. Some of the most liquid ETFs with the lowest spreads include SPDR S&P 500 ETF (SPY ) and iShares MSCI Emerging Markets ETF (EEM ).
Don’t forget to check out this article to learn more about the hidden risks associated with ETF investing.
How to Minimize Costs
Whether you are an active trader or barely touch your portfolio, there are practical ways you can reduce the cost of your ETF exposure. High-frequency traders should focus on the indirect costs of trading – namely, the tracking error and bid/ask spread. These costs can add up quickly if you are executing many trades each month. One of the best ways to overcome high costs is to select liquid funds whose performance closely mirror their underlying benchmark.
For infrequent traders, the indirect costs are less relevant because you intend to hold the asset for a long time. In this case, it doesn’t matter how much the bid/ask spread fluctuates or whether underlying liquidity is low. If you are in this boat, focus on ETFs with a lower expense ratio that trade close to their NAV.
To calculate an ETF’s cost for one year, there are three immediate factors you need to consider:
- The expense ratio (it remains as a percentage)
- The per-year bid/ask spread percentage
- The per-year commission (multiple the commission fee by two, divide by the total dollar amount and then multiply by 100)
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The Bottom Line
When it comes to ETFs, expense ratios are only the tip of the iceberg of the true cost of ownership. This has become more apparent in today’s low-growth environment, where cost-cutting has taken on a heightened level of importance. Through a combination of low-cost ETFs, smart trading strategies and a clearly defined time horizon, investors can minimize the impact of cost on their portfolio.
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