What ETFs Really Cost

August 01, 2017

Trading Costs

Among the other expenses investors must consider is the cost of trading.

ETFs are tradable vehicles like any single stock. That’s one of the hallmarks of the ETF structure relative to mutual funds. But buying and selling an ETF on an exchange has a price as well.

One of these costs is brokerage commissions to trade an ETF. The more you trade, the more you pay—that is, unless your ETF is part of a commission-free platform. Many firms, including Charles Schwab, Fidelity and TD Ameritrade, offer a broad list of ETFs commission free.

Another trading cost is the spread—the wider the spread, the more it costs you to execute your ETF trade. As we’ve said it before, where a mutual fund trades at NAV once a day, an ETF trades all day long. You’ll have to pay more to buy an ETF than you’d get to sell it at the exact same time. It’s just like a single stock.

The cost of trading is particularly important in leveraged and inverse funds, which are meant to be held for one or two days at a time. These are vehicles that are traded often, making the cost of trading almost more important in these types of funds than the expense ratio itself.

Tracking Difference

The second cost beyond the expense ratio that factors into the total cost of owning an ETF is tracking difference, commonly referred to as tracking error.

Passive ETFs are designed to replicate the performance of their underlying benchmark indexes minus fees. So you want to look for ETFs that have a median tracking difference that’s close to or better than its expense ratio.

For example, consider the iShares Core S&P 500 ETF (IVV). The fund has a 0.04% expense ratio, and it does a pretty good job of tracking its benchmark, with a median difference of -0.06% over a 12-month period—only 2 basis points lower than its expense ratio. ETF.com fund reports reflect tracking error as shown here:

 

ETFExplainerXLB

 

For a larger view, please click on the image above.

 

Tracking difference isn’t a cost that’s literally collected from the investor. You are not paying the issuer or a broker for that performance deviation from the index. Think of it more as the cost of underperforming your benchmark—the potential total return that did not materialize as if you had picked a bad manager, or a bad stock.

 

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