Exchange-traded funds, or ETFs, are designed to offer a low-cost way for investors to diversify their portfolios. They have become enormously popular with investors, which can be seen by how much money they now hold: $5.4 trillion as of July 2021.
Although low costs are one of the advantages of exchange-traded funds, they still come with fees that reduce an investment’s overall return. Understanding ETF fees can help you determine how they’ll affect fund performance and what you should be paying.
What affects the cost of an ETF?
Several factors can have an impact on an ETF price, including but not limited to:
ETFs trade on a stock exchange just like a stock, so investors may pay a flat commission fee every time they buy or sell shares in a fund. Also known as ETF transaction fees or ETF transaction costs, these may range from $8 to $30 at brokerage firms. Trading commissions are charged per trade, so they can add up if investors buy and sell a lot—and they’re usually more expensive when an order is placed in person or over the phone. Some ETFs are commission-free, but it depends on the ETF sponsor and the brokerage or platform used to buy and sell the fund.
ETF management fees are the main costs investors pay with this type of fund. These fees compensate the fund manager for expenses related to administering the fund. (Although most ETFs are passively managed, fund managers still incur expenses as part of normal business operations.) These expenses, such as employee salaries, custodial services, and marketing costs, are passed on to the investor.
The ETF expense ratio is the percentage of the fund’s total assets represented by management fees. This is an important metric to check because the expense ratio reflects how much an investor will pay annually. Fund managers calculate the expense ratio by dividing the fund’s operating expenses by the average assets of the fund:
Expense ratio = operating expenses / average assets
So if an ETF has an expense ratio of 0.75%, then an investor would pay $7.50 per year in fees for every $1,000 invested. The ETF expense ratio is sometimes expressed in basis points, so a 0.75% expense ratio would translate to 75 basis points.
Some funds may require more services and incur higher costs than others, so expense ratios can vary from fund to fund. The average expense ratio was 0.54% in 2020, but ratios may range from 0.05% to 1.5% in some cases.
On an ETF, the “bid” is what someone’s willing to pay for a share while the “ask” is the price someone’s willing to sell for. The difference between the two prices is the “bid-ask spread.” While the spread isn’t reflected in the fund’s expense ratio, trading an ETF with a large bid-ask spread reduces potential returns because they affect the purchase and sale prices. For instance, an investor might buy a share at $50 but can only sell it for $49.
Market price and NAV
The ETF’s market price isn’t considered a fee, but it is part of how much the ETF will cost. An ETF’s net asset value (NAV) is the actual value of the fund’s assets and cash. The price at which the ETF trades, or its market price, may either exceed or fall short of its NAV.
When the difference between the NAV and the market price varies too much, it can lead to higher costs and some reduction in the return on the fund. An ETF that’s trading above its NAV is said to be trading at a premium, while an ETF trading below its NAV is trading at a discount. Buying an ETF at a premium means paying more for the ETF than its holdings are actually worth.
A person’s investment decisions can influence what they pay in trading commissions, bid-ask spreads, and even operating expenses. Generally, an investor who takes a short-term approach may trade ETFs often and therefore pay more in commissions and deal with larger buy-ask spreads. An investor who takes a long-term, buy-and-hold approach will be more affected by the expense ratio because it’s a recurring management fee. In both cases, NAV premiums and discounts may affect an ETF’s performance based on how they move while the investor holds the ETF.
When are ETF fees deducted?
ETF trading commissions are charged per transaction, so investors pay these fees upfront when buying or selling shares.
The expense ratio works differently. Instead of paying money directly to a brokerage, the company managing the ETF deducts expenses from the fund’s net asset value. If an ETF has an expense ratio of 0.75%, the fund manager would deduct that amount from the fund’s assets under management each year.
An investor receives the returns on the ETF, minus the fees. So if a fund’s total return during a year is 15% before expenses and the expense ratio is 0.75%, the net return to the investor after expenses would be 14.25%.
That might not sound like much, but any fees paid reduce returns. The costs vary depending on the initial investment, fees, compounding method, and other factors. Let’s say a person invests $100,000 in an ETF that generates 4% in annual returns over the next 20 years. Assuming a 0.5% expense ratio, the investment could be worth about $200,000 two decades from now (not counting other costs and fees). But raise the expense ratio to 1.5%, and our investor winds up with about $165,000 (again, setting aside other costs).
ETF vs. mutual fund fees
ETFs and mutual funds share several similarities, starting with how they’re designed to bundle many securities together. However, the structural differences give ETFs a cost advantage. An ETF is traded on an exchange, so it can be traded throughout the day instead of just once a day like mutual funds. This makes ETFs more liquid. ETFs are often passively invested and therefore come with lower expense ratios. They also lack some of the marketing costs typically associated with mutual funds, which often come with a front-end load fee.
Investors can examine the relative costs of ETFs and mutual funds that track the same indexes. ETFs release their current holdings, shares outstanding, amount of cash, and accrued dividends on a daily basis. This makes ETFs more transparent than mutual funds, which usually disclose their holdings only quarterly.
The bottom line
Investors interested in buying ETFs will want to know all potential costs upfront. Investors typically research the ETF’s expense ratio and trading fees along with the quality of its holdings, how it’s managed, what it’s invested in, and how it fits within an overall financial plan.
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