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ETFs: How Much Do They Really Cost?

By Michael Iachini
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 effect for a premium or discount can be either positive or negative depending on which way the discount or premium moves between a purchase and subsequent sale.

  • 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.

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.

Trading commissions

Commission typically range anywhere from $4.95 to $19.95 when you buy or sell an ETF online.  Fees can sometimes be 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.

 

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.

Commission-free trades
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

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 (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 OER is an ongoing expense, it's relevant for all investors, but particularly for long-term, buy-and-hold investors.

When choosing between two or more ETFs that track the same market index (or similar indexes), be sure to compare their expense ratios among other factors. A little homework might pay off.

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.

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 itself
  • Market maker inventory management costs

Comparing bid/ask spread and expense ratio for two ETFs

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

Costs

ETF A

ETF B

Commission

$0

$0

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, pat zero commissions and all other costs remain constant, ETF A looks to have a lower cost despite its higher expense ratio.

Furthermore, the 0.03% spread of ETF A also indicates that it likely has a higher trade volume than ETF B, which might make ETF A preferable for liquidity reasons as well.

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%.

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 ($5 per trade)

$10

$300

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

$65

$1,065

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

Charles Schwab & Co., Inc. receives remuneration from third-party ETF companies participating in Schwab ETF OneSource™ for record keeping, shareholder services and other administrative services, including program development and maintenance.

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Important Disclosures

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

Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV)

Charles Schwab Investment Advisory (CSIA) is a team of investment professionals focused on rigorous investment manager research. Clients can find CSIA's top picks for Schwab OneSource mutual funds and ETFs in the Schwab Mutual Fund OneSource Select List® and the Schwab ETF Select List™.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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(0119-9SG1)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.