Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 7: Bid/Ask Spread]

Before taking on any ETF investment, it is important to consider the explicit costs incurred with trading and holding a fund.

Every ETF tries to reflect the performance of a benchmark index, minus fees. Specifically, the expense ratio.

An expense ratio is a fee every ETF investor will have to pay to compensate the investment company’s costs for operating the fund, determined through an annual calculation. The management expense ratio is calculated by dividing the fund’s operating expense by the average dollar value of assets under management.

Unlike mutual funds, ETFs have a much lower expense ratio, with an industry average at about 0.55%. Some broad-based index ETFs even come with expense ratios as low as 0.05%. ETFs come with lower fees because they do not incur the higher costs associated with operating a mutual fund, such as management fees, load fees for sale and distribution, paying a board of directors, shareholder accounting expenses and service or marketing fees.

Additionally, as ETFs continue to attract more assets, fund providers have been able to cut their fees. More notably, Vanguard has been reducing expense ratios on a slew of their funds, which now have an average expense ratio of 0.17%. This has fueled a growing “price war” among ETF providers, but Vanguard simply states that they are “passing on economies of scale.” [ETF Price Wars: Round 2]

ETF investors also incur costs, or commission fees, when executing trades. However, investors can work around this through some trading platforms that allow their clients to trade commission-free on select ETFs, including Charles Schwab, E*Trade, Fidelity, Firstrade, Interactive Brokers, Scottrade, TD Ameritrade and Vanguard.

While costs are a major concern, as they will eat away any potential returns, investors should also consider their investment horizons. If you are a long-term investor, commission fees will be less of a concern, so you should take the time to find the right fund with the right expense ratio you are comfortable with. In contrast, if you are an active day trader, multiple ETF trades can rack up a hefty commission fee, so you might be better suited with a commission-free broker.

For past stories in this series, visit our “What is an ETF?” category.

Max Chen 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.

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