ETF Education: Costs Beyond The Expense Ratio

[This article appears in our January 2018 issue of ETFR Report.]

An ETF’s expense ratio is an easy-to-understand, flat annual fee that helps you weigh the relative expense of one fund versus another.

But expense ratios alone don’t tell you the full story about how much an ETF really costs. To own any given fund, you’ll pay much more than just an annual management fee, including ...

Trading Commissions 
A commission is what your brokerage takes for making your trade. You pay this fee every time you buy and sell shares, no matter how big or small your trade (though sometimes a discounted rate is offered to more frequent traders).

Commissions depend on a variety of factors, including the brokerage you select, what kind of account you hold and whether you order in person, over the phone or online.

One thing’s certain, though: The more frequently you trade, the more you’ll pay in commissions, and that can erode your bottom line.

The good news is that many brokerages—such as Charles Schwab and TD Ameritrade—now offer commission-free ETF trading for certain funds. Still, exclusions sometimes apply, so make sure you read the fine print before investing.

Bid/Ask Spreads 
Technically, an ETF’s market price is not singular. Two prices actually matter: the price at which you can find a buyer to take your shares, and the price at which a seller will give them to you. These are the “bid” and “ask” prices, respectively, and the difference between them is known as a “bid/ask spread.”

The bid is usually lower than the ETF’s current share price, while the ask is usually higher. You’ll pay the full spread on every round-trip trade you make; meaning, the more frequently you trade shares, the more that bid/ask spreads will cost you.

Several factors dictate the size of an ETF’s bid/ask spread, including the liquidity of the underlying securities, how expensive it is for fund managers and market makers to offset risk, and the total supply/demand of actual ETF shares.

But like commissions, bid/ask spreads are unavoidable. You pay the current bid when you enter a fund and the current ask when you exit it. No exceptions.

Premiums/Discounts 
ETF premiums and discounts are exactly as they sound. An ETF trades at a premium when its market price exceeds the sum total of all the prices of its underlying holdings. An ETF trades at a discount when the reverse is true, and the ETF’s price falls below that of its underlying holdings.

By themselves, premiums and discounts don’t cost you anything. If you buy and sell your shares at the same 0.50%, then the net effect on your returns is zero.

Premiums and discounts only cost you if they change between the time you buy and the time you sell. If that 0.50% premium instead becomes a 0.50% discount, then you’ll lose 1% total on the round trip (assuming no price change).

ETF critics like to sound the alarm over premiums and discounts, but they’re actually normal. Most ETFs regularly carry small premiums or discounts, which arise organically from the supply/demand pressures that govern all marketplaces. (They can also emerge in other situations, such as when an ETF’s trading hours don’t match those of its underlying securities, as with some international funds.)

Plus, should premiums and discounts ever grow too large, ETFs have a built-in mechanism to realign prices with value through the creation/redemption process and the authorized participants that drive it.

Tallying Costs 
What cost affects you most depends on which kind of investor you are. Expense ratios impact buy-and-hold investors far more than active traders, who in turn are more impacted by commissions and bid/ask spreads. Premiums/discounts, though, are a wild card that can either help or hinder, depending on their value at trading time.