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Worth Considering: The hidden costs of exchange traded funds

David Peartree

Exchange traded funds have become popular with investors as the less expensive siblings of traditional mutual funds but, like mutual funds, the full cost to the investor is not so obvious. Investors who want to know the full cost need to dig deeper than the expense ratio.

Stock or bond ETFs are available generally at much lower expense ratios than comparable mutual funds. The expense ratio refers to the percentage of the fund used to cover administrative and management costs. These recurring costs of operating a fund are paid out of the fund assets and reduce the returns realized by investors.

The average annual expense ratio of a US stock mutual fund is approximately 1.2 percent. On an asset-weighted basis, meaning weighing the average expense ratio based on how dollars are invested across all available funds, the average stock fund has an expense ratio of about 0.8 percent. This means the average investor pays between $.80 and $1.20 annually for every $100 in the fund.

By comparison, the expense ratio of a typical U.S. stock ETF is a fraction of the cost of a comparable mutual fund. Expense ratios of 0.25 percent or less are common, and ETFs can be found for less than 0.10 percent. The expense ratio, however, does not capture all of the investor’s expenses.

The additional costs to ETF investors come in the form of transaction costs. Here are four additional costs ETF investors should be aware of:

Bid-ask spread

The bid-ask spread refers to the difference between the price for which an ETF share can be bought and the price at which it can be sold. Assume an investor buys an ETF for $50 per share and later decides to sell when the share price is still $50. If the current bid-ask spread is $.12, the investor will receive only $49.88 per share.

According to a recent article in The Wall Street Journal, the average bid-ask spread for a U.S. stock ETF is 0.25 percent and for a U.S. bond ETF it is 0.22 percent. For international stock and bond ETFs, the bid-ask spread ranges from .061 percent to 0.85 percent.

The bid-ask spread is not an annual expense like the expense ratio. It is only paid at the time of the purchase or sale. Over a period of many years, the impact of the bid-ask spread should not be significant. If, however, the investor only expects to hold an ETF for several years, the cost impact of the bid-ask spread can be more significant. Assuming, for example, a bid-ask spread of 0.60 percent and a holding period of three years, the additional expense is 0.20 percent each year.

The bid-ask spread is not fixed. It varies over time and even over the course of a single trading day. Spreads are often a bit wider during the first and last hours of the trading day.

Trading commissions

Another expense commonly overlooked is the commission associated with a purchase or sale, sometimes referred to as a ticket charge. Some brokerages offer commission free trades for certain ETFs, but more often the trading commission ranges from as low as $7 to as much as $20 per trade.

For the long-term investor who occasionally rebalances, trading commissions should not be a major concern. However, for an investor with a short-term horizon, especially if the account balances are modest in size, the impact of trading commissions along with the bid-ask spread may be an important consideration when choosing between an ETF and mutual fund strategy.

Trading commissions should also be considered if an investor is planning to add to an ETF through systematic purchases, say monthly, or if an investor wishes to invest a larger sum over a series of purchases. It may make sense to purchase less frequently or to consider using a similar mutual fund, particularly an index mutual fund, with a comparable expense ratio.

Funds trading at a premium or discount

ETFs sometimes trade at a premium or a discount to the value of the underlying stocks or bonds. Buying an ETF trading at a premium is an additional cost to the investor. So is selling an ETF that is trading at a discount.

The costs of poor trade execution

Many investors, including some financial advisors, routinely place ETF buy and sell trades as market orders. A market order guarantees the execution of a trade at the current market price. In most cases that is what the investor intends but, if the exchanges experience a hiccup, the investor may pay a steep price.

During the infamous Flash Crash in May 2010, market prices for certain ETFs plummeted precipitously in a matter of minutes. Over two hundred ETFs traded during the day at more than a 50 percent discount to their eventual closing price. Trades in some of the most egregious cases were canceled, but many investors incurred significant, unintended losses.

Sloppy trade execution can be expensive. Investors can guard against this by using limit orders. A limit order does not guarantee that a trade will execute, but it does ensure the price at which the investor will buy or sell. Most ETF trades, especially sales, should be placed as limit orders.

The typical stock or bond ETF will generally be less expensive than a comparable mutual fund, but investors should not assume that this is true in every case. The intelligent investor should be alert to the potential impact of various transaction costs. Though generally less expensive, trading ETFs is more complicated and potentially more risky than trading a traditional mutual fund.

David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, N.Y. 14625; email david@worthconsidering.com.

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