What ETFs Really Cost

August 01, 2017

How much does it actually cost to own an ETF? The expense ratio is a good initial indication of a fund’s cost, but it only tells part of the tale.

The total cost of ownership of an ETF goes beyond that headline fee, and it can vary depending on your holding period. Here’s a rundown of factors that add up to the true cost of owning an ETF.

Expense Ratio

The expense ratio represents all the expenses of the ETF divided by assets. This metric includes all internal costs of the fund, such as items we sometimes see itemized in a prospectus, like the management fee, which is how much an issuer charges for its fund management services.

And the way it’s collected is not as an upfront fee at the time of purchase. The expense ratio is accrued daily in the net asset value calculation of the ETF, which makes timing crucial in the calculation. If you bought a leveraged ETF with a 2% expense ratio, but you only held it for a week, you’d pay less than 0.04% in fees, according to FactSet data.

 

The 10 ETFs With The Lowest Expense Ratios

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The 10 ETFs With The Highest Expense Ratios

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

 

While the expense ratio is the “price tag” of any given ETF—the one metric often used to determine the cheapest option when comparing two similar funds—it offers an incomplete picture of the total cost of ownership.

 

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

 

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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.

 

Taxes

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.

Premiums/Discounts

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]

 

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