The hidden costs of ETFs and why you should not trade them frequently.

ETFs have gained enormous popularity in the US and for darn good reasons. These structures combined with the fast adoption of index investing have brought tremendous benefits to investors. One of the most familiar arguments to use ETFs is their lower cost. Are ETFs superior to mutual funds cost wise? The answer is “it depends”. Let’s explore when ETFs are not cost efficient investments.

ETF expense ratios are usually significantly lower than similar mutual fund competitors. That’s not surprising given ETF providers do not have to perform in-house accounting, budget for marketing costs, and pay enormous fees for asset managers. But not all ETFs cost the same for issuers to manage because of differences in methodology, liquidity, and composition. Moreover, unlike mutual funds, ETF expense ratios are only one of the expenses to the investor. What can make ETFs more expensive than a mutual fund are transaction costs. An investor can buy or redeem mutual fund shares directly with the fund, not generating any direct transaction expenses for himself. This is not the case for ETFs. Let’s break the costs down:

Additional costs of ETFs:

  1. Trading commission: brokerage firms charge an online commission typically ranging anywhere from $4.95 to $19.95 to trade ETF shares. Mutual funds don’t charge you trading commission if investors transact directly with the fund. Commissions can add up, particularly if one trades often. For example, say your commission is $10 each way (buy and sell) and you trade the ETF once a year. This will add up to $20 a year. If your investment was $5,000, your new ETF expense ratio becomes 40 bps higher ($20/$5000). Given you trade more often or smaller amounts, than this expense can quickly add up and make the ETF considerably more expensive than a mutual fund. Now, of course if the amounts you are investing are heftier, the commission expense becomes less relevant. Note that this is where brokers make their profits in ETF trading.
  2. Bid/ask spread: often overlooked by ETF investors is a significant cost. Market makers prefer you to trade ETFs often. This is the case because similar to commissions collected by brokers, the spread is a transaction expense except it is built into the market price and is paid on each round-trip purchase and sale. Best to think of it as a percentage of the value of the trade. To elaborate, the “ask” (or “offer”) is the market price at which an ETF can be bought, and the “bid” is the market price at which the same ETF can be sold. For example, you want to buy an ETF with a spread of 50 bps (0.5%), this would mean that if the price of one share is $100 (mid-price is always quoted), than the bid price will be $99.75 and the offer price will be $100.25. Put another way, you will buy the ETF at 100.25, and if you want to sell it immediately after, you will have to sell it at $99.75. The point is that you are never able to buy or sell the ETF at the mid-price (which is what it’s worth at that moment). So, given you trade the ETF once a year, you buy 50 shares and you sell them the same year, you would have to pay a round trip of 50 bps (or $25 for 50 shares at $100 price). You do this twice a year, and you expense doubles to 100bps. The larger the spread and the more frequently you trade, the more relevant this cost becomes. To provide you with some real statistics, the average holding period for an ETF is 1.5 months. This translates to 8 trades per year, which means that depending on the ETF spreads, they can cost investors anywhere between 8 bps to 400 bps per year. Again, you can quickly make an ETF significantly more expensive than a mutual fund. Note that this is where ETF market makers (APs) generate their profits for facilitating a market.
  3. The CHANGE in discount and premium to NAV: too many factors play into deviations to NAV that I simply would not be able to address it here but will look to creating another individual post. What I do want you to take in is that the premiums and discounts to NAV can affect your costs significantly if not handled appropriately. An ETF is said to be trading at a premium when its market price is higher than its NAV or simply put, the underlying holdings market value is lower than the ETF price. And an ETF is said to be trading at a discount when its market price is lower than its NAV, meaning the individual holdings market value is higher than the price. Market makers (usually called authorized participants or APs) job is to arbitrage away the differences between the ETF price and the underlying portfolio market value. Unfortunately, APs frequently don’t do such a good job for less liquid ETFs or ones with more exotic strategies or holdings. Even if a premium or discount exists, as long as it is consistent (you buy at premium, you sell at the same premium), it will not affect you negatively. But for example, you buy an ETF at a 100 bps premium and you sell it later at only 30 bps premium, your transaction expense is an additional 70 bps. Finding when the desired ETF has the most liquidity and trades within its normal band of premium or discount can be a beneficial exercise. These dues are paid to the market makers (APs) for having to take on additional risk when the holdings are illiquid or the strategy is hard to hedge.

Below table illustrates how cost should be examined:

 

  • Note that buy and hold strategy for an ETF is superior to a mutual fund.
  • Note that moving in and out of ETFs (even those with lower total cost ratio) is inferior to moving in and out of mutual funds. When one moves in and out of a mutual fund (what we call flow related expenses) the respective transaction expenses generated from the portfolio manager having to sell and buy securities is spread among all the investors in the mutual fund (which is unfair, yes).  This impacts performance of the mutual fund negatively and provides free liquidity to frequent traders. Most mutual funds imposed penalties on such behavior. 

etf-costs

Here is a summary of the main points and what you should get out of this:

  • Expense ratio is only one of the costs of investing via ETFs. Comparison to mutual funds should be made based on total cost.
  • The cost of buying and selling ETF shares falls to the investor, not the portfolio manager. Whether the investor considers that deal fair requires a thoughtful analysis of the total cost of ownership and intended trading frequency.
  • Recurrent ETF trading will be disastrous to one’s portfolio. Going back to the fact that investors trade ETFs on average 8 times a year, if one includes the spread, commission, and the possibility of premium/discount to NAV change, those combined can quickly wipe out all the returns generated compared to buy and hold strategy. Remember, when you trade ETFs often, it is the brokers and market makers that are getting rich, not you. Here again, low turnover and long-term investing should be encouraged even more so than with mutual funds.

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