Two Disclosed And One Hidden Cost Of ETFs


ETF market share has doubled in the last five years during the same period that mutual fund market share has been relatively stagnant. Although ETFs are generally cheaper and more tax-efficient than mutual funds, it’s important to count all the costs. Some newer ETFs, such as leveraged funds, appear to do a better job at maximizing fees than providing a healthy return to investors.

You cannot control the ups and downs of the market, but you can keep costs to a minimum. Some expenses are easy to comparison shop. You can find any ETF’s expense ratios and commission prices easily on brokerage or fund websites. But another cost, the bid/ask spread, is not readily disclosed and will require some additional digging to determine.

Expense ratios

The largest portion of your ETF costs is the expense ratio, the internal fee the fund company charges. This fee is extracted daily over the course of the year. ETF expense ratios are usually lower than mutual funds, largely because ETFs don’t need as many people to run them.

When you purchase an ETF, it requires little more administration than buying an individual stock. Mutual funds are different story, though. Mutual funds require recordkeeping operations and call centers. This extra administrative burden explains why ETFs can offer their product with a lower expense ratio.



In the chart below, you can see that the Vanguard S&P 500 ETF (VOO) has a minimal expense ratio of 0.05%. On a $10,000 investment, the annual expense ratio cost of holding this ETF is $5. Expense ratios climb as you seek out funds that target more obscure markets.




Trading ETFs frequently is a surefire way to make your broker rich. If you buy 1,000 shares of any ETF every month for a year, you pay 12 separate commission. That can mount up.

Commissions shouldn’t worry a long-term investor. For a $10,000 position, buying and selling the same position within a year will costs you $17.90 ($8.95 × 2) or 0.18% annualized. If you hold this position for five years before selling, the expense of commissions is just 0.04% annualized.

Bid/Ask Spreads

The third expense to consider is most often overlooked, but can be the most significant cost if you are not careful. In the day of floor traders, bid/ask spreads were determined through a cacophony of voices yelling their buy and sell offers. The difference between the lowest sell offer and the highest buy offer is called the spread. Today, limit orders (programs that stop buying or selling after a security reaches a certain price) or market makers who publicize their best offers set the spread.



Even if held for five years, the bid/ask spread adds a significant 0.1% annualized cost to a $10,000 investment in AUD but only half this cost for a similar investment in AUNZ. Our investment policy committee decided to go with AUNZ to minimize these costs.

Researching bid/ask spreads offers several challenges because most companies do not clearly communicate this cost. Morningstar offers this spread in their summary statistics but the spreads are reported in real-time which means they are constantly changing. When I was researching the bid/ask for AUD, it changed from 0.07% to 1.2% within a few hours.

Checking these spreads after trading hours is not a good gauge either. At the end of the trading day at 4:00 p.m. Eastern time, market makers often remove their bid and ask prices for ETFs. That’s to avoid getting caught in an unprofitable trade first thing in the morning if the index moves overnight. This causes the bid and ask prices to move away from one another and the spread to balloon.

There is a good way to determine the spread and account for volatility. If your ETF trades less than 100,000 shares per day, call the fund company and request the closing bid/ask spread for the last month. By taking an average of these spreads, you can fairly gauge what the typical cost might be. Additionally, if you are planning to purchase a larger amount of shares than is typical, I recommend you use a limit order to protects your purchase price.

Before purchasing an ETF, study the expense ratio, your commission price, and the bid/ask spread. That way you’ll know you’re not the patsy.

About the author

Matthew J. Illian, CFP®, AIF®
Matthew J. Illian, CFP®, AIF®


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