ETFs: Expense Ratios and Other Costs

An ETF's operating expense ratio is the annual rate that the fund (not your brokerage) charges on the total assets it holds to pay for portfolio management, administration, and other costs. As an ongoing expense, the operating expense ratio is relevant for all investors but particularly for long-term, buy-and-hold investors.

Most passively managed ETFs have lower expense ratios than actively managed mutual funds, but not all ETFs are friendly when it comes to fees. While the lowest-cost ETFs tend to have expense ratios less than 0.10%, the highest cost ETFs have expense ratios exceeding 10%. That's a difference of 100x.

When selecting an ETF, be sure to compare its expense ratio to the expense ratio of other funds, especially funds that track the same market index or provide exposure to the same type of assets (while also considering other factors).

An expense ratio tells you what percentage of an ETF's total assets are being used to cover its annual operating expenses. Think of an expense ratio as the cost of doing business, which is then passed on to investors.

The expense ratio is calculated by dividing a fund's total costs by its total assets. The expense ratio is usually stated as a percentage but is sometimes reported in basis points (or bps), which are simply 1/100 of 1% or 0.01%. ETF expense ratios accrue daily and are subtracted each day from an ETF's assets. This happens when the manager calculates the daily net asset value, or NAV, at the end of the trading day.

Expense ratios can vary widely. For example, if you look at a number of different funds, you may find expense ratios ranging from 0.03% (or even lower) to around 1.5% (or even higher). Some ETFs have expense ratios exceeding 10%.

The lowest-cost ETFs tend to track well-known broad-based indexes, such as the S&P 500^®. Higher-cost ETFs tend to be actively managed, track more complicated indexes, or provide exposure to an index or single stock that is either inverse or leveraged. Additionally, some higher-cost ETFs make investments in cryptocurrencies, business development companies (BDCs), and other ETFs or mutual funds (these are known as fund-of-funds). Alternatively, higher-cost ETFs may invest in strategies that provide exposure to derivatives (including futures, options, and swaps).

However, even small expense ratios can add-up over time, as shown in this investment fees calculator. Imagine investing $100,000 into a fund that generates 4% in annual returns over a 20-year period. With no costs and fees, you may end up with a little more than $219,000. With a middle-of-the-road expense ratio of 0.5%, your end result could be around $20,000 lower, not counting other costs and fees. And with a 1.5% expense ratio, your returns may be reduced by a little more than $55,000, again, not counting other costs and fees. The range and impact of expense ratios can be significant to your total return.

An ETF's expense ratio covers the fund's total annual operating expenses, which include management, marketing, and distribution fees. Also included may be fees for accounting, administration, recordkeeping, custodial services, and legal services. ETFs that hold other ETFs, mutual funds, or BDCs tend to have higher expense ratios, as these "acquired fund fees and expenses" are also reflected in the expense ratio. 

Some ETF issuers may provide fee waivers on certain ETFs. These reduce the ETF's expense ratio for a set period of time or until an ETF reaches a particular asset threshold. Details about fee waivers can be found in the fund's prospectus. ETFs with waivers will report both "gross" and "net" operating expense ratios. The gross OER is the higher fee that investors should be prepared to accept when the fee waiver expires.

It takes a lot to manage a fund, and some funds may require more services and incur higher costs than others. This is why expense ratios vary from fund to fund. But remember, ETF expense ratios are only one dimension to consider when assessing funds. A fund with a 0.00% expense ratio may be too good to be true if the fund sponsor doesn't have the resources to adequately support the fund and it ends up shutting down or raising its expense ratio in the future.

Typically, ETFs have lower expense ratios than mutual funds. Generally, low-cost equity ETFs will have a net expense ratio of no more than 0.25%. Low-cost equity mutual funds will have expense ratios of 0.5% or lower. Low-cost bond ETFs often have expense ratios under 0.2%, while low-cost bond mutual funds typically have an expense ratio of 0.4% or lower.

Today, many investors can trade listed ETFs online commission-free, including at Schwab. Thus, commission costs aren't as important of a consideration as they have been in the past. However, you'll still want to know what your broker charges for trade commissions, which can range from $0 to $25 or more (fees are often higher if you place a trade in person or over the phone). 

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 $5 commission on a $500 trade represents a somewhat large 1% fee, whereas the same commission paid on a $5,000 trade represents a 0.1% fee.

While commissions and expense ratios are straightforward, 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 by an investor, 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 the bid/ask spread as a transaction cost similar to commissions except that the spread is built into the market price and is paid during the purchase and sale. So, the larger the spread and the more frequently you trade, the more relevant this cost becomes.

The three main factors that drive bid/ask spreads include:

• The extent of market maker competition
• The liquidity of the underlying assets in the ETF
• Market maker inventory management costs

Let's compare costs for two hypothetical ETFs assuming a $10,000 purchase.

At first glance, it would appear 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 more of your investment in ETF B than ETF A because of the difference in spreads.

Despite its higher expense ratio, ETF A looks to have a lower total cost, assuming you hold each ETF for one year, pay zero commissions, and all other costs remain constant.

The last (and possibly least understood) potential cost comes from changes in discounts and premiums to net asset value (NAV) during the period you hold an ETF. This potential cost differs from the others because it can be a positive factor on overall returns—for example, it might increase your return instead of decreasing 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. An ETF is said to be trading at a discount when its market price is lower than its NAV—that is, 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. When material differences do manifest in ETF prices, large institutional investors (called authorized participants) usually help the stock market self-correct by attempting to profit from arbitrage trades that serve to better align an ETF's market price and NAV.

To illustrate this point, let's assume an ETF is trading at a premium of 1% to NAV. An authorized participant might attempt to capture that premium by 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 a stock 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. 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 many buy and sell orders are 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 U.S. stocks—typically display only small premiums or discounts. A good example of this is an ETF that tracks the S&P 500 and whose market price might not stray more than 0.20% 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.

You can tell if an ETF is trading at a premium or discount by checking its performance using Schwab's ETF quotes and research tool, where you can find the premium or discount as a percentage of NAV for the previous day's close. The average high and low for 1 month, 1 year, or since inception are also available.

Remember, the change in discount or premium is what 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, your return wouldn't be affected.

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've cost you 1%.

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.

Investors should also be aware that some investment products, such as exchange-traded notes (ETNs) and closed-end funds, also trade intraday like stocks and ETFs. However, because these products lack the complete in-kind creation and redemption process used by ETFs, discounts and premiums may be more problematic.

Your investment portfolio strategy greatly influences the net effect of commissions, operating expense ratios, 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.

The more you trade, the more important commissions and bid/ask spreads become, because you pay for each during every roundtrip made. On the other hand, the longer you hold an ETF position, the more important its 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.

Investors should remember that key considerations of an ETF's total cost of ownership include a combination of its operating expense ratio and costs of trading. Your investing strategy as well as the specific ETFs you select for your portfolio can make a big difference in the total cost.¹