It’s easy to see why exchange-traded funds (ETFs) are popular. They can offer exceptional liquidity and are a relatively inexpensive way to gain exposure to a variety of asset classes.
But some ETFs are cheaper than others. Here are three expenses to watch.
Commissions. Because ETFs trade on an exchange, you may have to pay a commission when you buy or sell one. Though some ETFs are available commission-free, many are not.
Operating expenses. These costs are generally levied at an annual rate known as an operating expense ratio (OER). Such fees cover the day-to-day costs of managing the ETF’s assets, administration and other costs. Investors don’t pay these fees directly. Rather, fund managers deduct the operating expenses daily from an ETF’s total average assets.
OERs are listed in an ETF’s prospectus. They can vary widely: from as little as a few basis points to as much as a few percentage points, with some ETFs charging up to 3.87%.1
Even small differences in fees can have a big impact on your portfolio over time. For example, imagine you invested $100,000 in an ETF with an OER of 0.1%. Assuming an annual return of 6% and no other fees, after 20 years your investment would have risen to $314,360.2 Now imagine you invested the same amount in an ETF with an annual OER of 0.5%. After 20 years, you’d have just $290,121.
The bid/ask spread. The difference between the price at which an ETF can be sold (“bid”) and the price at which an ETF can be bought (“ask”) is an often-overlooked cost. It is built into the market price and is paid on each roundtrip purchase and sale of an ETF. The larger the spread and the more frequently you trade, the more relevant this cost becomes.
Factors driving bid/ask spreads can include market liquidity and inventory-management costs recouped by the market makers who facilitate ETF trades. Bid/ask spreads tend to be lower for more actively traded and more liquid ETFs.
1Charles Schwab analysis of ETF annual report data in Morningstar Direct as of 4/16/2015.
2Based on calculations using the Financial Industry Regulatory Authority’s Fund Analyzer. Results are hypothetical.