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Beware of ETFs Hidden Costs

This article represents opinions of the author and not those of his firm and are subject to change from time to time and do not constitute a recommendation to purchase and sale any security nor to engage in any particular investment strategy. The information contained here has been obtained from ...

03/01/2013

Exchange-traded funds are a cost-effective way to build a well-diversified portfolio, but don’t just assume that all are inexpensive and diversified. Sometimes, you need to look very closely at hidden costs to determine the real cost of the investment.

Although ETFs are generally cheaper and more tax-efficient than mutual funds, it’s important to count all the costs. Some newer ETFs, such as leveraged funds, appear to do a better job at boosting their managers’ fees than providing a healthy return to investors.

You can’t control the ups and downs of the market, but you can keep costs to a minimum. Some expenses are obvious, and it’s easy to comparison shop. You can find any ETF’s expense ratios and commission prices easily on brokerage or fund websites, or third party sites such as Morningstar. But another cost, the bid/ask spread, is not readily disclosed and requires some additional digging to determine.

Expense ratios. The largest portion of your ETF costs is the expense ratio, the internal fee the fund company charges. This fee is extracted daily over the course of the year. ETF expense ratios are usually lower than mutual fund ones, largely because ETFs don’t need as many people to run them.

Most ETFs track index funds, which require them only to passively buy and sell securities to mirror a benchmark like the Standard & Poor’s 500 stock index. But the vast majority of mutual funds’ portfolios are actively traded, meaning that spend a lot of time and money researching things to buy in hopes of besting the market.

When you purchase an ETF, it requires little more administration than buying an individual stock. You buy and sell them on an exchange, just like a stock. Mutual funds are different story, though. You buy and sell the fund directly from them, which requires recordkeeping operations and call centers.

But don’t assume the lower costs of lighter administration will be automatically passed along to investors. Some ETFs see this reduced cost as an opportunity to maximize their profits.

There no good reason to pay more than 1% for any investment fund. Even this threshold may be too high, but it’s easy to remember. You can find the expense ratio listed on most financial websites or in the fund’s fact sheet and prospectus.

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