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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.

In the chart below, you can see that the Vanguard S&P 500 ETF (VOO) has a minimal expense ratio of 0.05%. On a $10,000 investment, the annual cost of holding this ETF is $5. Expense ratios climb as you seek out ETFs that target more obscure markets.

Our investment committee recently searched for a fund that gives us exposure to Australian bonds denominated in local Aussie dollar currency. Two similar ETFs that offer this are the WisdomTree Australia & NZ Debt ETF (AUNZ) and the PIMCO Australia Bond Index ETF (AUD). They both have the same expense ratio of 0.45%, but if you look beyond expense ratios, they carry very different costs.

Commissions. Your broker charges a commission on most investments bought and sold on an exchange. Commissions fell dramatically over the years as trading moved online and away from floor traders. Back in 2000, an equity purchase from Charles Schwab typically charged $29.95. Today, the same purchase only costs $8.95 or less.

Mutual funds do not charge a trading commission, although some of them carry a load, or one-time sales fee, sometimes as high as 5.75%. But you can get around that by sticking to no-load funds. All ETFs, though, charge a commission every time they trade.

Trading ETFs frequently is a surefire way to make your broker rich. If you buy 1,000 shares of any ETF every month for a year, you pay 12 separate commissions. That can mount up.

Commissions shouldn’t worry a long-term investor. For a $10,000 position, buying and selling the same position within a year costs $17.90 ($8.95 × 2) or 0.18% annualized. If you hold this position for five years before selling, the expense of commissions is just 0.04% annualized.

Bid/ask spreads. The third expense is often overlooked, but can be the most significant cost if you are not careful. In the day of floor traders, bid/ask spreads were determined through a cacophony of voices yelling buy and sell offers. The difference between the lowest sell offer and the highest buy offer is called the spread. Today, limit orders (programs that stop buying or selling after the security reaches a certain price) or market makers who publicize their best offers set the spread.

If you can buy an ETF for $10 per share or at the same time sell the same ETF for $9.95 a share, the spread is 5 cents, a cost of 0.5%. Like commissions, bid/ask spreads are transactional charges. The more often you trade, the more you pay.

The bid/ask spread is most costly in thinly traded positions. The VOO ETF has trading volumes of nearly a million shares every day, and the spread is an inconsequential 0.01%. However, fewer than 8,000 AUD shares exchange hands every day, and the average spread is 0.52%. That’s a 52 times greater cost due to poor liquidity.

Description: ETF expenses

Graph: Matthew Illian

Even if held for five years, the bid/ask spread adds a significant 0.1% annualized cost to a $10,000 investment in AUD, but only half this cost for a similar investment in AUNZ. Our investment policy committee decided to go with AUNZ to minimize these costs.

Researching bid/ask spreads offers several challenges because most companies do not clearly communicate this cost. Morningstar offers this data in their summary statistics but the spreads are reported in real-time, meaning they are constantly changing. When I was researching the bid/ask for AUD, it changed from 0.07% to 1.2% within a few hours.

Checking these spreads after business hours is not a good gauge either. At the end of the trading day at 4:00 p.m. Eastern time, market makers often remove their bid and ask prices for ETFs. That’s to avoid getting caught in an unprofitable trade first thing in the morning if an index moves overnight. This causes the bid and ask prices to move away from one another, and the spread to balloon.

There is a good way to determine the spread and account for volatility. If your ETF trades less than 100,000 shares per day, call the fund company and request the closing bid/ask spread for the last month. By taking an average of these spreads, you can fairly gauge what the typical cost might be. Additionally, if you plan to purchase a larger amount of shares than is typical, I recommend you use a limit order to protect your purchase price.

Warren Buffett warns novice investors with a poker analogy. He says that if you don’t know who the patsy is after 30 minutes of playing, you’re the patsy. Those who fail to do their homework pay the price.

Before purchasing an ETF, study the expense ratio, your commission price and the bid/ask spread. That way you know you’re not the patsy.

 

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Matthew Illian, CFP, AIF, is a wealth manager for Marotta Wealth Management Inc. He is based in Richmond, Va., providing fee-only financial planning and wealth management at www.emarotta.com and blogging at www.marottaonmoney.com.

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