Investing in ETFs? Don’t forget to Consider The Total Cost
While many investors are quick to praise the cost efficiency of ETF’s as well as seeking out the cheapest options, what many focus on is simply the expense ratio. The problem with this is that the expense ratio is only 1 of number of vital elements that should be taken into account when investing in ETF’s.
If a person is going to compute a complete and accurate cost of investing in ETF’s, they are going to need to consider not only additional explicit costs and fees that could be incurred from trading but also commissions, effective interest rates and bid-ask spreads. If that’s you, you’re in luck as this blog is going to look at these additional costs and fees so that you know exactly what you’re getting into. Enjoy.
It’s important to note that the effective percentage that commissions represent can vary significantly from one ETF to another. The fact is, trading fees are measured in absolute dollar terms (generally). For an investor who’s putting significant dollar amounts into ETF’s and has very little turnover, commissions will probably impact their bottom line minimally. Investors using a more active approach however will find that commission costs can add up quite quickly. For example, an investor with a $200,000 portfolio who pays $10 to execute every trade and makes 2 trades a month (2 buy and 2 sell orders) the annual commission cost can exceed $400, something that adds approximately 25 basis points to their total expenses.
One of the best ways to lower commission expenses is to take advantage of free commissions. The best news for ETF investors is that they have several options for avoiding commissions altogether. For example, Schwab and Vanguard allow you to trade ETF’s for free if you’re a brokerage client. IShares has recently partnered with Fidelity and they are now offering free ETF trading on 25 of their most popular iShare ETF’s.
Some ETF’s have effective interest rates that are more advanced and thus need to be taken into account when figuring out overall costs. Leveraged ETF’s and futures-based commodity products, those that utilize derivatives to establish exposure, in general maintain cash balances that can earn interest. What that means is that if you have invested cash that’s being held by leveraged and commodity ETF’s, it’s going to have a higher yield, something that will offset the expense ratio charged by the fund and lower the ETF’s overall cost. This of course can have a material impact on the bottom line return of an ETF, something that companies that issue leveraged ETF’s pride themselves on.
One element that isn’t as explicit as expense ratios and commission fees but needs to be taken into the total cost picture of an ETF because it can add up so quickly is the bid-ask spread. Without going into mind numbing detail, the bid-ask spread component of the ETF expense equation, depending on the period of time that a person holds on to their investment, could actually dwarf their expense ratio component. Thus the bid-ask spread is definitely something that should be taken into account when investing in ETF’s.
If you have questions about investing in ETF’s or any other type of acid class, or you just have questions about personal finances in general, drop us a note or send us an email and we’ll get back to you with advice and answers.
Filed under: Investing
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