With the U.S. Department of Labor’s (DOL) fiduciary rule on the horizon (June 9th is the next deadline), investing costs and fee transparency inside retirement plans has taken center stage. Financial advisors, as a result, will need to clearly articulate not just the cost of their advice, but the cost of the investment vehicles they use for clients.
Because exchange-traded funds increasingly are becoming the investment vehicle of choice, advisors should know how to explain ETF costs to clients. Let’s examine six key areas that deal with ETF ownership costs and how to explain them.
Brokerage Commissions
The cost for buying and selling ETFs is known as a “brokerage commission.” Thankfully, the advent of online trading has greatly reduced brokerage commissions and many leading online platforms now charge well under $10 per trade.
Some online brokers offer commission-free ETF trading on a limited menu of funds. However, the expense ratios for some of these commission-free funds vary widely and investors need to choose wisely. For example, some ETFs could have substantially higher expense ratios compared to similar ETFs not on the commission-free list, thereby reducing the cost advantage of zero trading commissions for long-term buy-and-hold investors.
Since commissions are typically fixed fees, their impact becomes less meaningful as the size of a trade or the length of an investor’s holding period increases.
Expense Ratios
Fees to cover the day-to-day work of managing ETF assets, administration, and other services are known as the fund’s “expense ratio.” The expense ratio is charged to fund investors at an annual rate and the fee is deducted daily from an ETF’s total average assets.
Even a seemingly small difference in expenses can have a big impact on your bottom line. For instance, a $100,000 investment in an ETF that provides a 6 percent return and an annual expense ratio of just 0.10 percent would rise to $314,360 in 20 years. In contrast, that same dollar amount invested in an ETF that charges higher expenses of 0.50 percent would rise to just $290,121. Put another way, the investor who didn’t pay attention to fund expenses needlessly forfeited $24,239!
Bid/Ask Spreads
Like individual stocks, ETFs have bid/ask spreads. This represents the difference between the highest price that a buyer is willing to pay for an ETF and the lowest price that a seller is willing to accept to sell it. Spreads can be significant for ETFs with limited trading volume or for ETFs that invest in less liquid securities. Generally speaking, ETFs with the highest daily trading volume will have the tightest bid/ask spreads, thereby reducing the frictional cost of buying or selling funds.
Unbeknownst to many, mutual fund investors also bear the cost of bid/ask spreads. However, these costs are spread among mutual fund investors, whereas ETFs externalize these costs by spreading them among authorized participants, market makers, and investors who trade ETF shares.
Morningstar keeps track of ETF bid/ask spreads and reports them in percentage terms. Similar to a fund’s expense ratio, the lower the number, the better.
Tracking Error
For ETFs linked to an index, tracking error measures how much a fund deviates from the performance of its underlying benchmark. Under optimal circumstances, ETF investors should expect to receive the performance of the fund’s underlying index minus fees. But actual results can vary due to a variety of factors like a fund’s legal structure, index sampling, securities lending and market volatility.