There’s little debate that exchange-traded funds (ETFs) have democratized investing. In addition to offering access to previously hard-to-reach parts of the market (think commodities and precious metals), ETFs have helped drive down investing costs in many areas of the market.
However, even relatively low fees and expenses can add up over time. So here are three costs to consider when investing in ETFs, and how to keep them to a minimum.
When you buy and sell ETFs, your brokerage company may charge a trading commission, which covers the costs associated with executing and clearing a trade. Some brokerage firms offer commission-free trades on certain ETFs, while Schwab offers them on all ETFs. But if you’re paying a commission to trade ETFs, there are a few things to know:
- The more often you trade, the more you’ll pay in total commissions.
- Most firms charge a flat fee, so the percentage cost will be larger for smaller trades than for larger ones.
- If you’re buying in person or over the phone, you’re likely to pay a higher commission than if you trade online.
Commissions are important for everyone to consider. But because commissions will play a more significant role in your total cost of ownership if you trade frequently or in small dollar amounts, active traders, in particular, should pay attention to the cumulative cost of commissions.
2. Expense ratios
The expense ratio is the annual rate a fund charges to cover its operating costs. Fund managers collect a small portion of the total annual expense from the ETF each day. As a result, the longer you invest in a fund, the higher the cumulative cost of this fee will be.
Also, be sure you understand the difference between an ETF’s net expense ratio and its gross expense ratio. The former is what shareholders pay as a result of the temporary fee waivers some ETF managers have introduced to attract new investors. The latter is what shareholders pay if and when those waivers expire. So, if you see a fee waiver in the prospectus, look for the expiration date and know that the fund could cost you more in the future.
3. Bid/ask spread
When you research ETFs, it’s easy to overlook the bid/ask spread, which is the difference between the market price at which a market maker is willing to buy an ETF (the bid) and the price at which the market maker is willing to sell it (the ask). It’s not a fee, per se, but rather a cost of investing.
Bid/ask spreads are often a reflection of an ETF’s liquidity. Popular, highly liquid ETFs, such as those that track the S&P 500® Index, tend to have very small bid/ask spreads. That’s because there’s enough demand for both the ETF and the underlying securities it holds that the market maker assumes little risk in facilitating transactions.
But with less-liquid ETFs—ones that access niche areas of the market, for example—market makers may have a harder time finding buyers and sellers, which increases their risk of facilitating a trade. To make up for this risk, the market maker charges you a higher ask when you buy the ETF and offers a lower bid when you’re ready to sell it, effectively eating into your potential profits. The more frequently you trade and the larger the spread on each transaction, the more relevant this cost becomes.
Despite the fact that fund fees have plummeted over the past two decades, it still pays to do your homework. Spending a few extra minutes to evaluate the true cost of an ETF can help you make sure that headline fee you’re paying isn’t too good to be true.