Costs of investing in ETF’s

Transaction Costs

  • Brokerage
    • Given that ETFs trade like any other share – investors have to pay brokerage every time they buy and sell ETFs. Therefore, investors should plan to invest a minimum of $4,000 in one transaction so as to keep brokerage transaction costs under 50 bp (assuming brokerage of $7-$10 per transaction).
  • Total Expense Ratio
    • The Total Expense ratio (TER) that includes shareholder transaction costs and annual management fees for ETFs can be as low as 10 bp and in some cases higher than 100 bp. On average investors should expect to pay about 35-40 bp as TER for investing in ETFs. This compares to over 150 bps on an average for most mutual funds. While these differences seem small, over say 20 years, they can compound into a significant and noticeable difference.

Bid-Ask Spread

  • Investing in ETFs can prove be an expensive affair if the ETF does not have adequate trading volumes that results in very high bid/offer spreads or differences between buying and selling prices.
  • While this is not a fixed ‘cash’ cost of investing in ETFs, nevertheless it can be disadvantageous to investors who want to buy and sell an illiquid ETF with short-term profit objectives.

Loss of interest on Delayed Dividend Payout

  • Some ETFs only payout dividends on a semi-annual basis even though they receive the same in cash on the underlying stock’s dividend payout date. The loss of interest on such trailing dividend payouts is an additional cost (albeit small in the current environment when interest rates are low) that investors should account for.

Cost of Borrow

  • Investors who wish to short ETFs incur an additional cost i.e. the cost of borrowing ETF units for shorting. This will add to the overall transaction cost and reduce the price at which the investor plans to make the sale.

1.1.5      Why ETFs have lower expense ratios as compared to MF’s?

  • Management Fees – Mutual funds have higher management fees as they employ more staff to actively manage the fund as compared to passively managed ETFs.
  • Rebalancing Fees – Actively managed mutual funds constantly need to churn their portfolios to maximize returns for their investors. This entails higher trading and administrative expenses that is absent in ETFs.
  • Cost of Holding Cash – Mutual funds need to maintain a cash reserve to meet day-to-day redemption requests by shareholders. This aspect is also called ‘cash drag’ and is not an issue with ETFs.
  • 12B-1 fees – Mutual funds charge ‘12b-1’ fees that are typically not charged by ETFs. 12b-1 fees represents expenses used for advertising and promotion of the fund. 12b-1 fees are generally limited to a maximum of 1.00% per year (.75% distribution and .25% shareholder servicing) under FINRA Rules.