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6 ETF Costs You Need to Know About Before Investing

02/15/2019

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ETFs have become a very popular choice for investors in recent years. This type of investment is relatively new when compared with other investment options, but ETFs are quickly becoming a go-to investment product for many. With $5 trillion held in ETFs globally, it’s easy to see how popular these investments really are.
Of course, just like any other investment, ETFs have their pros and cons. No investment is the perfect investment and it’s important to understand the full costs associated with ETFs. This is especially true since ETFs are often marketed as low-cost investment opportunities and the associated costs could come as a surprise to investors who have chosen ETFs solely due to cost.
In this article, we will discuss some of the most important costs that investors should know about before investing in ETFs. This is not meant to discourage investment in ETFs but, rather, show true ETF costs and allow investors to make more informed decisions.

Important ETF Costs to Understand

With the popularity of ETFs, the true costs of investing can get lost in the hype about low fees. While it is true that the management fees of ETFs may be lower than other comparable investments, there are a number of other fees to be aware of.

As mentioned, this list is not meant to discourage ETF investing. Instead, with the full picture of all fees associated with ETF investing, people can be more aware and less shocked by surprise fees that may arise.

1. Commission and Trading Fees

Just like any other large fund, ETFs must make trades at some point. This could be because asset allocation or weighting has fallen outside of intended standards or there is a change being made to the index that the ETF was designed to track. Some ETFs make very few trades while some are more active.

Regardless of how many trades a fund manager makes, the costs of selling and buying assets must be passed on to investors in the fund. The fund cannot simply swallow these costs. As a result, investors may notice their fees are higher than expected after the fund has accounted for commissions and trading fees.

With all of this said, ETFs do have a method of helping to reduce the amount of fees and commissions paid to acquire assets. Instead of buying assets on the open market, ETFs can issue creation units to trade with authorized partners that, in turn, provide the fund with the assets they are seeking to add.

Best of all, the authorized partners cover the costs of the transaction, so the ETF does not have pass on costs to investors.

2. Capital Gains Taxes

Capital gains taxes are something that many investors are aware of and, in turn, try to reduce as much as possible. Most investors understand that if they sell an asset for a gain then they will be subject to capital gains taxes. However, these investors are not always aware that a fund can incur capital gains taxes even if the individual investor makes no movement on their own.

When a fund sells assets at a gain, they can incur capital gains taxes and those taxes must be passed on through to individual investors. This is a very similar concept to the commissions and trading fees mentioned above. For investors who were hoping to reduce their tax obligations, this can be one of the most shocking and unwelcome ETF costs.

Of course, for those who are truly concerned about taxes, it’s important to maximize usage of tax advantaged accounts first before investing in accounts that are not tax-advantaged.

3. Tracking Error

When an ETF is created, it is set up to track a specific industry or index. This gives investors a simple way to replicate the returns of the industry or index in question. However, it does not guarantee that those returns will actually be 100% accurate.

This difference is known as tracking error. A very small tracking error indicates that the ETF was created correctly to track the index in question. However, a large tracking error shows that the ETF was not very accurate, and investors may have missed out on potential gains.

Tracking error could be a shock for some investors that were expecting to closely follow well-known indices like the S&P 500. This is a cost that is often not accounted for as it is impossible to predict future results. However, investors can look to historical tracking errors to get an idea of how well the fund manager is able to track the index or industry they have been tasked with tracking.

4. Bid-Ask Spread

Since an ETF is traded on the open market (hence the name exchange traded fund) it is subject to market pricing. When investors want to buy an asset on the open market, they issue a bid price.

When investors want to sell, they issue an ask price. The difference is the bid-ask spread.

For highly liquid assets, the bid-ask spread will be very close and trades can happen quickly. Buyers and sellers often don’t overpay or undersell from the prices they had bid or asked for. However, not all assets are traded within a tight bid-ask spread. This could prove to be another unexpected cost for investors.

Paper gains are just that – gains on paper but not necessarily in reality. Actual gains are not realized until assets are sold. Investors can try to sell their assets at any ask price they wish, it does not necessarily mean that the sale will be fulfilled. An investor looking to sell their ETF shares may find that they are unable to sell at their ask price and must, instead, sell at the bid price of buyers if they wish to actually complete the sale.

This price differential between expectations and reality can cut into potential gains for investors. In illiquid markets, the problem can be amplified. However, if markets are liquid then this may not be much of a concern.

5. Expense Ratio

The expense ratio is one of the least surprising ETF costs for most investors because it is widely understood as a basic cost of investing. Whether choosing an ETF or a mutual fund, most people expect to pay the Management Expense Ratio (MER) to invest.

However, many investors do not understand everything that goes into the expense ratio and how it may change. Included in this fee are all of the management fees and expenses that a fund can incur throughout the year. Hiring managers and staff is a fairly obvious expense of any fund.

With that said, there are some fees like custodial fees which are part of an expense ratio that the average investor is not aware of. An ETF that holds foreign assets may have a higher custodial fee and, as a result, it may be more cost effective for Americans to hold shares of ETFs that invest in American stocks.

6. Net Asset Value

Since an ETF holds a bucket of assets, the fund has a net asset value (NAV). Generally, ETFs trade very closely to their net asset value but this is not always the case. The net asset value can determine whether an ETF is good value or poor value for buyers. The same is true for sellers.

If an ETF is trading above net asset value, then it may be a great time for investors in the fund to sell their shares at a significant profit. However, this would be a poor time to purchase shares simply because the underlying assets are not matching the share price of the ETF.

However, if an ETF is trading below its net asset value then this would indicate a good buying opportunity. Sellers, on the other hand, may want to hold off from selling as they will not get the value they should.

When an ETF’s price falls below its net asset value, large institutional investors will often buy shares to sell at a gain when the price corrects. However, this is only worth it once the ETF value strays further away from its net asset value so investors should not count on this significant buying activity rescuing ETF share price in every situation.

More Information, More Informed Investing

ETFs are always going to be a valuable part of overall portfolio construction. When used in combination with other investment options, investors can build a strong portfolio that matches their needs and risk tolerance. Clearly understanding all of the ETF costs they may face simply allows investors to make the best decisions possible.

DISCLOSURES

Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

If you have questions about the true costs of ETF investing, please contact Linden Thomas and Company today.

Linden Thomas & Company

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