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 mutual funds are transaction costs. An investor can buy or redeem mutual fund shares directly with the fund, not generating direct transaction expenses for himself. It is not the case for ETFs. Below are the three significant expenses investors will incur using ETFs compared to Mutual Funds.
Bid/ask spread:
Market makers want investors to trade ETFs often. Spreads are transaction expenses, except they are built into the market price and paid on each purchase and sale. It is best to think of them 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 that same ETF can be sold. If an investor is looking at an ETF with a current mid-price of $ 100, a spread of 50 bps (0.5%) means that the ETF can be sold at $99.75 per share and bought at $100.25. So, given that you trade an ETF once a year, you buy 50 shares and sell them the same year, you would have to pay a round trip of 50 bps (or $25 for 50 shares at a $100 price). You do this twice a year, and your expense doubles to 100bps. The larger the spread and the more frequently you trade, the more relevant this cost becomes. The average holding period for an ETF is 1.5 months. This short period means that the average investor will trade an ETF 8 times per year. The spreads are how ETF market makers (APs) generate profits to facilitate a market.
The CHANGE in discount and premium to NAV:
An ETF is said to be trading at a premium when its market price is higher than its NAV, which means that the underlying holdings’ market value is lower than the ETF price. Inversely, an ETF trades 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 authorized participants or APs) aim to arbitrage away the differences between the ETF price and the underlying holding market value. Unfortunately, APs frequently don’t do such an excellent 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 a premium, you sell at the same premium), it will not affect you negatively. But for example, if you buy an ETF at a 100 bps premium and sell it later at only a 30 bps premium, your transaction expense is an additional 70 bps. Finding when the desired ETF has the most liquidity and trades within its average band of premium/discount can be a beneficial exercise.
Trading commission:
Some brokerage firms charge an online commission from $4.95 to $19.95 to trade ETF shares. Mutual funds don’t charge you a trading commission if investors transact directly with the fund. Commissions can add up, mainly 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). Since you trade more often or in smaller amounts, this expense can quickly add up and make the ETF considerably more expensive than a mutual fund. Of course, if the amounts you invest are heftier, the commission expense becomes less relevant. Note that this is where brokers make their profits in ETF trading.