Investing is not free. ETF investing is one of the most efficient methods to invest, but there are still numerous fees and even hidden costs that eat into returns. Investors pay a multitude of fees depending on the types of investments they hold. Some of these fees are hidden, some are charged on transactions and some are charged annually.
Certain costs are unavoidable, but others can be reduced or avoided. The first step is to be aware of all the fees you are paying.
The most obvious costs to an ETF investor are the annual management fees and commission paid to a broker to buy and sell that ETF. The other costs are often hidden.
ETF issuers charge an annual fee in return for managing an ETF. This fee includes the overheads associated with running an exchange traded fund, staff costs and the managerís fee. These are published as an expense ratio (ER). The average ER for US listed 0.44%, the lowest are around 0.03% and the highest around 3%.
Every day the NAV (Net Asset Value) of the fund is adjusted downward by a tiny fraction. The daily NAV adjustment should be the ER divided by the number of trading days in the year (approx. 250). So, if the ER is 0.2%, then the daily adjustment will be about 0.0008%.
Expense ratios are supposed to make it easy to compare the costs of various ETFs on a like for like basis. Unfortunately, not all managers calculate expense ratios the same way. Some managers will publish their target ER, but actually charge higher fees if the total assets in the fund are lower than a specific level. Check the small print if you are investing in ETFs with less than $50 million under management.
Transaction Fees within an ETF
Expense ratios donít include transaction fees associated with rebalancing the holdings in a fund. Every time an ETF buys or sells shares, they pay commissions. This happens whenever the underlying index is rebalanced (usually quarterly) and when new units are created or redeemed. When ETF issuers see demand for the fund increasing they will issue new ETF units and buy all the shares held in those units. When investors begin selling ETFs they will sell shares and cancel units. Every time they do that, the fund pays commission.
This process usually only accounts for a small portion of the fund, so the cost to the entire fund is negligible. But if an ETF is very small and has few investors, the actions of one investor can have an impact on the entire fund.
Whenever you buy or sell an ETF you will pay commission to a broker. Discount brokers have brought trading commissions down considerably, and introduction of flat fees also means that the larger the trade, the lower the relative cost.
This is great news for investors using ETF rotation strategies. Logical-Investís strategies typically have no more than three transactions every month. At a $5 commission, thatís a maximum of $180 a year, which is 1.8% on a $10,000 portfolio and 0.36% on a $50,000 portfolio.
Spreads, Slippage and Market Impact
The invisible costs that come with buying and selling ETFs relate to the price you pay or receive. The actual value of an ETF is its Net Asset Value, but you will trade at either the bid or offer price. The difference between the bid and offer is the spread. If you buy at a price higher than the NAV, thatís an invisible cost that you are in effect paying. If you sell at a price below NAV, you are incurring another hidden cost.
The size of the spread depends on liquidity. The bigger an ETF and the more widely followed its underlying index, the lower the spread will be. For example, there are a number of large ETFs tracking the S&P 500 index, so itís in the issuers interest to keep spreads narrow. At any one time, there are numerous buyers and sellers active in each ETF.
On the other hand, an ETF that holds shares in a niche index will have fewer buyers and sellers active, and the issuers and market makers will have little incentive to keep the spread narrow.
When market volatility increases you may find it difficult to trade at the price you would like to. You may enter a buy order between the bid and offer price only to see all the bids and offers move higher. If you ultimately end up trading at a higher price, that is slippage which is another hidden cost.
Retail investors are unlikely to have market impact costs unless they are trading in very illiquid ETFs. Market impact occurs when your buying and selling orders actually cause prices to move, creating slippage. This is an issue for large funds and an area where retail investors have an advantage.
Broker Assisted Trades
Discount brokers are set up for online trading, however if you want to trade over the phone you can. Just be aware that you will pay more for a trade placed over the phone. While online trades typically cost $4.95 to $6.95, broker assisted trades will cost $20 to $45 at most of the well-known brokers.
Commission Free ETFs
These days most of the discount brokers offer their clients access to commission free ETFs. That means that when you buy or sell them you pay no commission. However, when you check the fine print you will probably find that if you sell that ETF within 30 days, you will be charged even higher commissions. And, there are other hidden fees.
Commission free ETFs might be free to buy and sell but they are not free to own. Stock brokers earn fees on these funds by charging the fund manager, and the fund manager adds that fee to the annual fee they charge investors.
Taxes are a cost that are worthy of an entire book. There are a number of ways taxes can hit investorís long term returns. In particular dividend taxes and capital gains tax account for the biggest impact. Itís not possible to avoid paying taxes entirely, but there are more and less tax efficient ways to invest. This guide†provides a basic overview of tax efficient investing.