Cost is a big factor that most investors look at when making an investment decision on a particular financial product. Exchange traded funds are often touted for their lower expense ratios in comparison to mutual funds, however, the expense ratio is not the only cost.
“I’d like to frame the question a bit differently here. I posit that when considering ETF costs, one should not merely ask what they charge. Instead, ask yourself what you initially expected to receive and whether or not it was what the product has provided historically,” Abraham Bailin for Morningstar wrote.
The expense ratio is just the start of what it will cost to invest in an exchange traded fund. The expense ratio is the flat out cost that the provider charges to invest in an ETF, but the estimated holding cost captures the realized cost of replicating an index. [ETF Fees: The Lower the Better]
Abraham Bailin for Morningstar reports that indices with high turnover or relatively illiquid constituents can be more costly to replicate. For funds that track these types of indices, we would expect the estimated holding cost to be higher than the expense ratio.
There is a gap in the return from an ETF and that of the index it is tracking. This figure changes each year, and can add to the cost of ownership, or can also be positive, adding to return. [ETF Liquidity is More Than Trading Volume]
Another amortized cost of holding an ETF is tied to the funds’ liquidity.Liquidity can be thought of as the sensitivity of an asset’s price to the act of buying or selling. Assets that are bought and sold in large amounts without much impact upon an assets’ price are known to be liquid. Therefore, an ETF that is liquid and has high trading volume is a good sign, and can indirectly keep costs down. [An All Seasons Model ETF Portfolio]
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.