ETFs are cheap, but not always in the way you think.
ETFs have probably done more to improve investor outcomes than any innovation in financial services since the mutual fund. A big part of that is the cost equation. The average equity ETF, for instance, has an expense ratio of just 0.45%, vs 1.37% for the average equity mutual fund.
But headlines aren’t the whole picture. How should you think about your real, total costs of ownership. Ultimately, it breaks down into four components.
1. Internal Costs
The most obvious costs are the ones written right on the label. You can go to any ETF here at ETF.com just by adding /(ticker) to the end of it. Want to see the expense ratio for the PIMCO Total Return ETF (BOND | B)? Just type “etf.com/bond” into your browser and a full description of the ETF is right there on the page.
But that number is a bit more complicated than you might think. Two costs are typically quotes for ETFs.
A “management fee” is the amount the fund issuer charges the fund for management. The “expense ratio” is all of the expenses of the fund divided by average assets. It’s further complicated by the fact that issuers will often cap the total expenses at a certain level, voluntarily covering fund expenses above a certain amount. We quote the all-in, capped cost generally.
There can also be surprises in this total expense number. If a fund has to pay dividends on short positions, or has to account for tax liabilities, you can see some surprisingly large numbers. You’ll generally see those outliers explained in the text of our reports.
Are these costs always cheaper than mutual funds? Not necessarily. ETFs can be less expensive for issuers to run—no shareholder servicing costs, no 12b-1 fees and no externalized trading expenses—but some of the cheapest mutual funds give ETFs a run for their money.
Still, in most cases, similar strategies are going to be cheaper in an ETF wrapper than in an open end mutual fund wrapper.
2. Tracking Difference
Most ETFs track an index.
But managing money against an index involves more than just pushing a button: It requires actual skill and a surprising amount of decision making. We calculate “Tracking Difference” statistics for most ETFs, which measures how well a fund tracks its index over one year holding periods.
“Good” management has a median tracking difference close to or better than its expense ratio, and little variability from one holding period to the next. After all, if you managed your fund perfectly, you’d underperform the index by exactly as much as your expenses.
But funds often miss the mark—or beat it—for a variety of reasons. They have transaction costs form some positions and cash drag from dividends that the indexes don’t have to deal with, and they can earn money from securities lending or manage their local international tax withholdings better than the indexes assume, boosting performance.
The way ETF.com presents tracking difference, the impact of expense ratio is already baked in—it includes all internal factors that affect performance relative to the index being tracked.
3. External Costs
Unlike mutual funds, ETFs have to be bought and sold on an exchange, and that transaction isn’t without some expenses.
The most knowable cost is the commissions you’ll spend on your trade. If you plan on holding a position for 10 years, the $10 you pay your discount broker to make the trade may not matter at all. If you’re trading every day, it can be a big deal.
Luckily, many discount brokerages now have relationships with ETF issuers to offer a set of ETFs without any commissions at all. Here are the notable examples:
|Firm||Fund Families||# Of ETFs|
|TD Ameritrade||iShares, iPath, Vanguard, SSgA, PowerShares, Van Eck, PIMCO, Market Vectors, WisdomTree||101|
|E*TRADE||Global X, DB-X, WisdomTree||106|
|Schwab||Schwab, SSgA, Guggenheim, PowerShares, ETF Securities, US Commodity Funds, ALPS, Direxion, Global X, IndexIQ, PIMCO, ProShares, WisdomTree||175|
It’s worth noting that just having more ETFs available isn’t always the winning solution here. You need to evaluate each ETF in the commission free list just as carefully as you would if you weren’t trading commission-free.
And of course, because you’re buying and selling on exchange, you have a spread to contend with. Unlike a mutual fund, which trades at net asset value (NAV) once a day, you’ll have to pay a little bit more to buy an ETF than you’d get to sell it at the exact same time, just like a stock.
Hundreds of ETFs trade at tiny spreads all day long, but it always pays to look at the Tradability tab on an ETF.com fund report to get a sense of what your round trip trading costs are going to be.
The last and most finicky component of your total costs are the taxes you’re going to pay on your investment returns. This can often be the trickiest part to figure out, especially when dealing with ETFs that have different structures.
Of course, if you hold your ETFs in a tax-deferred account like an individual retirement account, you don’t have to worry about this, but if you’re investing with taxable dollars, it’s another place to do homework.
The good news is that as a class, ETFs have been phenomenally tax-efficient vehicles when compared with mutual funds. Because ETFs can constantly “wash” their tax basis through the creation and redemption process, many ETFs carry enormous tax-loss overhangs which will keep them from paying out capital gains for years to come.
Of course, you’ll still have to pay taxes on dividends received, and on any gains when you sell.
Pay special attention to commodities ETFs when it comes to considering your tax positions. Commodities ETFs are generally either taxed like collectibles (precious metals) or like futures positions (marked to market, and then at 60/40 split long-term/short-term capital gains).
That can lead to some surprises, come April. For more information, check out our definitive ETF taxation guide.
The Big Picture
It’s tempting to come up with a magic number that will apply to everyone that says: “This is your cost.” But that would be a disservice the very flexibility ETFs offer investors.
Your cost for owning an ETF will be the combination of the four I’ve isolated in this blog which, again, are as follows:
- Internal Costs
- Tracking Difference
- Transaction Costs
But it’s important to remember but the last two will always vary based on how you trade, what kind of account your using, and what your holding period is.
Most investors will do well sticking to low-cost, high-quality ETFs that track their indexes well, and trading them with good execution hygiene. But it’s always a good idea to dig in and understand what your personal cost of ownership is going to be.
At the time of this writing, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.