Following our introduction to ETFs and why they are increasingly popular with traders we delve into the costs of trading ETFs.
The terms, cost and fees obviously have different meanings. An ETF has its own share of costs and fees associated with it.
For starters, when you buy or sell ETFs there is the standard commission that is applied. In a way, this is similar to what one would pay when buying or selling stocks. Among the many costs associated with trading ETF’s nothing can come close to the type of coverage the management fees receives when it comes to exchange traded funds.
Management fee is a fee that is deducted from the fund’s portfolio to compensate the fund manager for overseeing the holdings and administration of the ETF. While management fees were once high, they have significantly come down as competition among ETF issuers increase.
Spreads are another factor to consider with the costs of trading ETFs. The spread is the difference between the bid and ask prices for a security (or an ETF), also known as the selling and buying price. Typically, highly liquid ETFs and those with huge volumes have a tight spread.
But the more an investor steers into exotic ETFs the lower the volumes get and the spreads start to increase. As a comparison, the spread for high volume stocks are around a few cents and can be around 10 – 20 cents for lighter traded instruments.
In recent times however, there has been a growing debate as to what exactly are the costs with an ETF. According to a research paper published on The Journal of Portfolio Management, by authors James J. Angel, Todd J. Broms, and Gary L. Gastineau, they argue that because the value of an ETF is derived from its underlying holdings, the ETF slippage which is the difference between the transaction price and the ETF’s net-asset-value (NAV) is the real cost to the investor for trading an ETF.
A better measure of the costs of trading ETFs is the expense ratio which is the money paid by the investor for buying or selling the ETF.
The expense ratio combines all the fees such as management fee, administrative fees, and so on. The expense ratio is the percentage of assets deducted each fiscal year for the fund’s expenses.
The expense ratio can be as high as 1% but is different from each of the ETFs. Usually ETFs with smaller assets have high expense ratios and conversely an ETF with higher assets attract smaller expense ratios.
The SPDR S&P500 Index Trust ETF is an index ETF with the lowest expense ratio of 0.05%
Index funds tend to have lower expense ratios compared to ETFs that track a wider range of assets. This is because replicating the returns from one security such as an index is less intensive compared to tracking the performance of multiple assets in an ETF.
Beginners guide to exchange traded funds – 5 Takeaways
- Exchange traded funds combine the characteristics of stocks and mutual funds and are traded on an exchange. The ETF’s gives investors the option to trade or invest in a security with lower fees
- ETF’s are quite popular in the U.S. compared to Europe. Still, globally ETF investing is starting to show signs of improvement. By some estimates, total money inflows into global ETF’s are expected to top $7 trillion by 2020
- ETF investments are a better option for investment as it allows investors to track or gain exposure to exotic markets such as emerging market funds which usually come with higher yields or returns
- Exchange traded funds are widely sought after due to the fact that they are liquid and transparent. ETFs are preferred by traders as well because they can be short-sold and are traded on margin
- There are some costs of trading ETFs, which are combined into an expense ratio, which is an annual fee that is incurred for the shareholders of the ETF.
