ETFs: How Much Do They Really Cost?

Key Points

  • When investing in ETFs, consider these four potential costs: commissions, operating expenses, bid/ask spreads, and changes in discounts and premiums to net asset value.
  • The total cost of owning an ETF can vary significantly depending on the asset class the fund invests in, as well as your portfolio strategy.
  • Essential reading for investors needing to understand ETF expenses.

Exchange-traded funds (ETFs) are similar to mutual funds except that they trade intraday like stocks. They've become extremely popular because they're considered to be a less expensive way for investors to gain exposure to a diverse array of asset classes, including domestic and international stocks, bonds and commodities.

Even though ETFs can be relatively inexpensive, investing in them does include certain costs. The most obvious are commissions to trade ETFs (though some may be available commission-free) and operating expenses incurred while holding them. Trading costs can also include two misunderstood and sometimes overlooked items: bid/ask spreads, and changes in discounts and premiums to an ETF's net asset value (NAV).

What's more, both the nature of the asset class (broad category of investment) an ETF invests in as well as your portfolio strategy can affect the total cost of owning ETFs.

Let's look at each of these factors in turn.

Trading commissions

In general, brokerage firms charge an online commission typically ranging anywhere from $8.95 to $19.95 when you individually trade an ETF without the assistance of a broker, in much the same way they charge to execute stock trades. The fee level can vary even more depending on your brokerage firm, account type, how often you trade, and whether you transact online, in person or over the phone. Many brokerage firms are now waiving commissions on certain ETF trades. For example, you can trade ETFs in Schwab ETF OneSource™ commission-free online in your Schwab account.1

In cases where you pay commissions to trade ETFs, keep these two points in mind:

  • The more frequently you trade, the more you'll pay in total commissions.
  • Because commissions are typically a flat fee no matter how large or small the trade, the percentage cost per trade will be larger for smaller trades and smaller for larger trades. For example, a $9 commission on a $900 trade represents a somewhat large 1% fee, whereas the same commission paid on a $9,000 trade represents a 0.1% fee.

The main takeaway is that commissions can play a more significant role in your total cost of ownership if you trade frequently or in small dollar amounts. This means that active traders should pay more attention to commission costs than long-term, buy-and-hold investors.

It also means that ETFs may not be the best choice if you frequently invest small amounts of money over long periods of time, unless you're choosing ETFs that can be traded commission-free.

Operating expenses

Most ETFs have attractively low operating expenses compared with actively managed mutual funds, and to a lesser extent, passively managed index mutual funds.

ETF expenses are usually stated in terms of a fund's operating expense ratio (sometimes abbreviated as OER). The expense ratio is an annual rate the fund (not your broker) charges on the total assets it holds to pay for portfolio management, administration and other costs.

Since the expense ratio represents recurring fees that you'll incur for as long as you own an ETF, it's relevant for all investors, but particularly for long-term, buy-and-hold investors.

In cases where two or more ETFs track the same market index (or similar indexes), be sure to compare their expense ratios. A little homework might pay off, though of course you should focus on more than just expenses when choosing an ETF.

Bid/ask spreads

Commissions and expense ratios are fairly easy to understand, but ETF investors often overlook a third cost: the bid/ask spread.

The "ask" (or "offer") is the market price at which an ETF can be bought, and the "bid" is the market price at which the same ETF can be sold.

The difference between these two prices is commonly known as the bid/ask spread. You can think of it as a transaction cost similar to commissions except that the spread is built into the market price and is paid on each roundtrip purchase and sale. So, the larger the spread and the more frequently you trade, the more relevant this cost becomes.

Many complicated factors drive bid/ask spreads, but three stand out:

  • The extent of market maker competition.
  • Market maker inventory management costs.
  • The liquidity of the ETF itself.

Let's explore these in more detail.

Each ETF has at least one market maker whose role is to set a bid and offer price in the absence of public buy and sell orders. Market makers help ensure that transactions in an ETF are as smooth and continuous as possible by facilitating orderly trading and helping to provide liquidity when buying and selling imbalances exist.

The more market makers that participate in the trading of a particular ETF, the narrower the bid/ask spread tends to become. This is because investors' trades will be executed at the best bid and offer prices available, so the market makers have to compete with one another to attract order flow.

Market makers' inventory management costs are another factor that influences bid/ask spreads. For example, market makers might hold direct long or short positions in the ETFs they deal in, but in order to minimize their own risks, they'll often hedge their positions using derivatives, or by buying or selling baskets of the securities that underlie the ETF. (They eventually unwind these baskets themselves or exchange them directly with the ETF itself.)

What's important to understand is that the market maker will attempt to pass these costs along to investors in the form of larger bid/ask spreads. Remember, they also have to be competitive in their bid and ask prices, or they won't be able to attract order flow.

A third factor influencing bid/ask spreads is the liquidity of the ETF itself. The liquidity of an ETF is linked to the number of investors interested in buying or selling a position in the ETF at any point in time. The notion that higher liquidity can shrink bid/ask spreads makes intuitive sense—the more investors interested in being party to a transaction, the closer the highest price offered to buy and the lowest price offered to sell are likely to be. Similarly, less-liquid ETFs tend to have larger bid/ask spreads.

Let's bring some of these points together by comparing two hypothetical ETFs.

Hypothetical bid/ask spread and expense ratio on a $10,000 trade

Costs

ETF A

ETF B

Expense ratio

0.52% ($52)

0.29% ($29)

Bid/ask spread

0.03% ($3)

1.32% ($132)

Total cost (roundtrip cost after one year)

0.55% ($55)

1.61% ($161)

At first glance, it would appear that ETF B is less expensive because of its lower expense ratio.

After closer examination of the bid/ask spreads, however, you learn that ETF B has a much larger spread than ETF A. This tells you that in a roundtrip trade, you're estimated to lose 1.29% more of your investment in ETF B than ETF A because of the difference in spreads.

Assuming you hold each ETF for one year and other costs remain constant during that time, ETF A looks to have a lower cost despite its higher expense ratio and assuming commissions are the same.

Furthermore, the 0.03% spread of ETF A also indicates that it's likely more liquid than ETF B, which might make ETF A preferable for reasons other than just those relating to cost.

Discounts and premiums to NAV

The fourth (and possibly least understood) potential cost comes from changes in discounts and premiums to NAV during the period an ETF is held. This potential cost is different from the others in that it can also be a positive factor on overall returns—for example, it might increase your return instead of decrease it.

An ETF is said to be trading at a premium when its market price is higher than its NAV—simply stated, you're paying a bit more for the ETF than its holdings are actually worth. And an ETF is said to be trading at a discount when its market price is lower than its NAV—you're buying the ETF for less than the value of its holdings.

For example, imagine an ETF that trades in the market at $30 per share. If the individual stocks the ETF holds are worth only $29.90 per fund share, then the ETF is trading at a premium of 0.33%. Conversely, if the stocks the ETF holds are worth $30.25 per fund share, the ETF is trading at a discount of 0.83%.

In general, most ETFs exhibit small discounts and premiums, and when material differences do manifest in ETF prices, large institutional investors (called authorized participants) usually help the market self-correct by attempting to profit from arbitrage trades that serve to bring an ETF's market price and NAV back into better alignment.

Using an example to illustrate this point, let's assume that an ETF is trading at a premium of 1% to NAV. An authorized participant might attempt to capture that premium by simultaneously purchasing a basket of the underlying securities the ETF tracks, exchanging the basket of securities for shares of the ETF, and selling the shares in the open market.

This process of exchanging baskets of the securities in an index for shares of the ETF is called the in-kind creation/redemption mechanism, and it's the reason ETF premiums and discounts are generally self-correcting. Deviations from NAV create profit opportunities for authorized participants, and as they conduct arbitrage trades, they help bring the ETF's market price into better alignment with its NAV.

In the case of an ETF that trades at a premium, for example, authorized participants selling newly created ETF shares increase the supply in the market, which helps drive down the price of the ETF closer to its NAV.

When the securities that make up the index an ETF tracks are easily priced because there are many buy and sell orders being placed in a centralized exchange, "creating" a basket of securities to replicate the index is relatively straightforward.

As a result, ETFs that track heavily traded, highly liquid markets like US stocks typically display only small premiums or discounts. A good example of this is an ETF like SPY, which tracks the S&P 500®, and whose market price tends to stray no more than 0.05% or so away from its NAV.

However, ETFs that track less liquid markets such as high-yield bonds, commodities or emerging markets can display differences of 1% or more—usually due to lack of liquidity, but sometimes because of more complex factors.

When it comes to ETFs that track fixed income asset classes like high-yield bonds or municipal bonds, for example, one of these complex factors is the in-kind creation/redemption mechanism mentioned above.

Pricing bonds that don't trade on a centralized exchange is much more challenging than pricing stocks in the S&P 500. Complicating matters further, there are many more bonds out there than stocks, which makes replicating an index even more difficult. These challenges make the in-kind creation/redemption mechanism less effective for fixed income ETFs, which may lead to large, volatile premiums and discounts.

It's worth noting that some ETFs accept cash creations and redemptions along with in-kind creations and redemptions. A cash creation works as you might expect—an authorized participant delivers cash in exchange for newly created ETF shares. ETFs that accept cash tend to trade at a smaller premium because it's easier for authorized participants to create new shares when the ETF price rises above NAV. Similarly, cash redemptions help keep discounts in a smaller range. Unfortunately (when it comes to premiums and discounts), most creations and redemptions are done in-kind.

You can tell if an ETF is trading at a premium or discount by checking the "Quote Details" section for the ETF on Schwab.com, which shows the premium or discount as a percentage of NAV for the previous day's close.

Remember, it's the change in discount or premium that matters most. Moreover, these changes aren't always necessarily a drag on performance—the effect can be either positive or negative depending on which way the discount or premium moves between a purchase and subsequent sale.

For example, if an international fixed income ETF trades with a somewhat persistent 0.6% premium to NAV, and you bought and sold the ETF at that same premium, there would be no effect on your return.

The risk comes when that premium erodes or even becomes a discount during the time you own it. In our example, if you bought the ETF while it was trading at a 0.6% premium but sold it while it was trading at a 0.4% discount, the change during the roundtrip would have cost you 1%, (assuming for simplicity that you bought and sold the ETF at the same price).

Although realizing small gains or losses from potential changes in discounts and premiums might be acceptable in many cases, and possibly even unavoidable for certain ETFs, the main point is to be aware of the risks involved—and to be purposeful when trading ETFs that may exhibit excessively large or volatile discounts and premiums to NAV.

Portfolio strategy: long term vs. active trading

Your portfolio strategy greatly influences the net effect of commissions, operating expenses, bid/ask spreads, and potential changes in premiums and discounts to NAV.

In the table below, we estimate the hypothetical cost of ownership for a long-term, buy-and-hold investor and an active investor who both invest in the same ETF.

Total estimated ETF costs during one year

Description of costs and assumptions

Long-term, buy-and-hold investor

Active investor

Average trades per year ($10,000 per trade)

2 (1 roundtrip)

60 (30 roundtrips)

Commissions ($9 per trade)

$18

$540

Bid/ask spreads (0.25% average per roundtrip)

$25

$750

Operating expenses (0.3% per year on $10,000 balance)

$30 (ETF held every day in the year)

$15 (ETF held for half of the days in the year)

Changes in discounts/premiums

$0

$0

Total

$73

$1,665

The more you trade, the more important commissions and bid/ask spreads become because you pay each during every round-trip made. Commissions are especially important to consider when trading in small dollar amounts because even though the fee might be small in dollar terms, it might turn out to be relatively large in percentage terms.

On the other hand, the longer you hold an ETF position, the more important the expense ratio becomes because it's a recurring management fee paid to the fund for as long as you own the ETF.

Discounts and premiums to NAV can either drag or boost performance depending on how they move during the time you hold the ETF. So it's both your own investing style combined with the various costs of the specific ETFs you invest in that comprise your total cost of ownership.2

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Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.