When investing in an exchange traded fund, investors should understand the total cost of ownership, which includes costs outside the expense ratio price tag.
“The expense ratio is just one component of the total cost of ownership, which can be broken down into trading costs and holding costs,” writes Morningstar analyst Michael Rawson.
Under trading costs, investors should also keep in mind brokerage commission fees, trading bid-ask spreads and potential market impact of trades. [Assessing the Total Cost of ETF Ownership: A Real World Example]
Additionally, looking at holding costs, investors need to consider sampling errors, other trading costs, securities lending and the expense ratio.
Trading costs are typically a major consideration for more short-term traders who won’t stick to an investment long enough to see significant holding costs. Moreover, large investors who have a large impact on a fund’s average daily trading volume will also take particular note of potential trading costs as they can affect a security’s price through sheer volume.
For instance, traders want tight bid-ask spreads, or the difference between the highest price a buyer is willing to pay for the ETF’s share and the lowest price at which a seller is willing to part with the share. According to Morningstar data, ETFs with more assets have tighter bid-ask spreads, and U.S. stocks have tighter spreads than less-liquid securities like bonds or international stocks that trade in different time zones. [Dissecting The Cost of Owning an ETF]
Consequently, the tight bid-ask spreads in something like the SPDR S&P 500 ETF (NYSEArca: SPY) helps explain why large institutional investors keep returning to SPY to capture broad S&P 500 exposure when the iShares Core S&P 500 ETF (NYSEArca: IVV) and Vanguard 500 Index (NYSEArca: VOO) both show cheaper expense ratios.
Over longer periods, holding costs will have a larger affect on total costs as the initial trading costs are amortized. Consequently, long-term investors are more apt to hold onto VOO or IVV, capitalizing on the ETFs’ cheaper expense ratios.
“Long-term investors should place more emphasis on holding costs, while traders should focus on trading costs and keep in mind that the most liquid ETP in a category can change over time, as long-term investors gravitate toward the most efficient ETP,” Rawson added.
Moreover, more long-term investors should keep in mind other holding costs, such as sampling errors, which entails comparing an ETF’s ability to track its underlying index. Ideally, an ETF would perfectly reflect its underlying benchmark, but ETFs may exhibit slight premiums or discounts to their net asset value, so investors should watch out for any glaring discrepancies.
For more information on ETFs, visit our ETF 101 category.
Full disclosure: Tom Lydon’s clients own shares of IVV, SPY.