Another important cost to consider is taxes—how your returns are taxed. Unfortunately, there’s no easy way to determine what that will be, because ETFs come in many structures, shapes and sizes. (For more on this, see: ETF Legal Structures, Regulation And Taxes)
But if you realize capital gains when you sell your ETF, you are going to pay taxes on that. If you are collecting dividends from your ETF in a taxable account, you are going to pay taxes on that. Taxes are a given.
FactSet ETF analyst Scott Burley notes that tax-related costs vary: “Dividends are taxed immediately, but capital gains are only taxed when shares are sold. You’ll have to pay eventually if you ever intend to sell, but it’s always better to pay later. If you don’t need the income now, yield is just an extra tax liability.”
“This is why year-end capital gains payouts are a problem,” he added. “Most investors don’t need or expect them, and unlike dividends, they’re usually avoidable by the fund management.”
The good news is that ETFs are touted for their tax efficiency, and that has to do with the wrapper’s creation/redemption mechanism, which keeps most ETFs from issuing capital gains at the end of the year.
ETFs can trade at premium and discounts. Sometimes that can mean additional costs. If you buy an ETF at a premium and sell it at a discount, you’re losing money. But the reverse would mean you can make money in the transaction.
“The problem with premiums and discounts isn’t really the cost per se,” Burley said. “If a fund doesn’t trade close to its NAV, it implies that the creation/redemption mechanism has broken down, and you can’t trust that the fund will actually deliver the returns you expect. Even if you’re able to buy at a large discount, you might be forced to sell at an even larger discount.”
“There’s also the possibility that the underlying assets are so illiquid, the fund has taken on a price discovery role. In that kind of situation, premiums and discounts don’t represent a cost,” noted Burley.
Total Cost of Ownership
Going back to our example, the iShares Core S&P 500 ETF (IVV), when it’s all said and done, the total cost of ownership of the fund beyond the expense ratio would be that if you hold the fund for one month, you’d pay on average about 0.05% in tracking difference, 0.03% points in dividend taxes (assuming a 20% rate), and 0.01% in trading spread.
Again, that is on average, because all these figures can vary. There’s also the possibility of a capital gains tax, which would depend on price performance.
On an annual basis, these averages would go up 12 times, except for trading spread,” Burley explained.
The challenge investors face when looking at the total cost of ownership of an ETF is that, outside the expense ratio, others costs fluctuate. Consider that in the case of IVV, in any given year, when all cost ranges are considered, you could lag the index by up to 0.25% or beat it by up to 0.04%, depending on when you buy and sell.
“IVV is a very liquid, well-managed fund,” Burley said. “Changes in premium/discount, trading spreads or tracking can affect what you’ll ultimately pay.”
Contact Cinthia Murphy at [email protected]