Exchange traded funds(ETFs) are touted for many reasons, but a major plus of ownership is the low fees. In fact, ETFs are favored to supposedly be one of the least expensive funds to own.
Just what exactly goes into owning an ETF? The actual costs involved in transacting and owning an ETF can go beyond the expense ratio. [Major Differences Between ETFs and Mutual funds.]
Ben Johnson for Hemscott News reports on some major factors that make up the cost of an ETF.
- Trading Costs: These costs include brokerage commissions, bid-offer spreads, and market impact. These can vary, depending on where you’re trading. With price wars intensifying, it’s now cheaper than ever (and sometimes free) to trade ETFs and places like Schwab, Vanguard, Fidelity, Scottrade and E*Trade. Bear in mind, though, that if you’re trading multiple times a day, then these trading costs will be a significant fraction of your total costs. But if you’re trading less frequently, then the less of an issue this becomes.
- Total Expense Ratio (TER): This ratio represents the portion of your investment that will be extracted by the fund on an annual basis for their efforts. This charge covers costs incurred by the fund which can range from trading expenses to marketing budgets and custodial fees to index licensing costs.
- Tracking Difference: Tracking difference is an implicit cost of ETF ownership. All else being equal, ETFs will by definition produce returns that lag their benchmark by an order of magnitude equal to their TER. [The Causes of Tracking Error in ETFs.]
- Index Turnover: While index investing is a passive strategy, indexes do experience turnover by varying degrees. Different strategies such as fundamental indexing, equal weighting or indexes that only contain a portion of the market such as value, growth, and high-dividend ETFs, all tend to have even higher turnover.
- Dividends: The timing and tax treatment of dividend payments are two additional potential sources of tracking troubles for ETFs.When funds receive dividends from securities located in multiple tax jurisdictions outside their domicile, the associated foreign dividend withholding taxes can create an additional drag on fund performance. [More Facts About ETFs and Taxes.]
- Commodity Costs and ETNs: Many exchange traded commodities (ETCs) and exchange traded notes (ETNs) will charge a range of fees in addition to their expense ratios. These include custody and storage fees (unique to physical precious metals funds), collateral costs, and index licensing costs. Collateral charges reflect the cost of holding collateral to reduce counter-party risk in synthetic ETC and ETN structures. [4 Commodity ETF Types.]
Other factors will come into play when you’re trading ETFs, one of the most important of which is the intraday indicative value, a real-time snapshot of the cost of an ETF. The number will give you an idea of the relationship between the underlying basket of securities and the share price of the ETF. If it’s below the bid/ask, buying is not a good idea; if it’s above, it is. This information can be found in a variety of places: on many financial sites, it can be located by typing in “.IV” after any ticker symbol.
If you’re a knowledgeable trader, you can save a significant amount of money by choosing ETFs carefully and knowing where the greatest expenses lie.
For more stories about ETFs, visit our ETF 101 category.
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.