The impact of fees on an ETF portfolio is one that most people tend to overlook. While the general consensus is that ETFs have some of the lowest embedded management fees in the business, often times the round trip costs of trading or hiring an investment adviser go overlooked. To understand the true cost of these funds on your net investment return, it’s important to analyze the full menu of transparent and non-transparent fees that you may be subject to.
The most well-known barometer of ETF fees is the embedded expense ratio that is charged by the fund manager for operation and administration. These can range anywhere between 0.04% - 2.00% depending on the fund company and index style. In addition, many ETFs that invest in business development companies or “fund of funds” often list the acquired expenses of the underlying holdings as well. This can lead to an add-on effect that multiplies the cost of your investment several times over.
Generally speaking, companies such as Vanguard and Charles Schwab are known as some of the lowest-cost providers of ETFs in the industry. The Schwab U.S. Large-Cap ETF (SCHX) charges a minimalist expense ratio of just 0.04% to own 750 of the largest and most liquid stocks in the United States.
In addition, newcomers like Fidelity are taking note of the success of the low-cost model by coming to market with sector ETFs that sport expenses as low as 0.12%. The Fidelity MSCI Health Care Index ETF (FHLC) is just one example of this style of fund.
While paying attention to expenses, particularly among similar strategies is important, it should not be an overriding factor in your investment decision making process. Often times picking a unique style or index can lead to significant outperformance versus the lowest cost offering in a particular class of funds.
Another important consideration is transaction costs, particularly on smaller accounts that can quickly see a significant performance impact from buying and selling ETFs. These costs are charged by your brokerage company to purchase or sell an ETF on your behalf. Transaction fees typically range between $5 - $20 per trade, but several discount brokerage companies offer online transaction-free pricing for a select menu of ETFs as well.
The selection of a brokerage company or specific investment may well come down to the tradeoff between transaction-free pricing and paying trading costs that could potentially eat into profits. This is even more poignant if you tend to trade often or in smaller size.
One overlooked cost of buying and selling ETFs is the arbitrage effect of a bad execution price. Certain ETFs with low volume, illiquid underlying holdings, or those that carry an uncharacteristic premium/discount to their net asset value can result in inefficient pricing. Even the slippage of a few pennies on the entry and exit of a $10,000 trade can immediately put you at a disadvantage and erode gains that would otherwise enhance your total return.
To combat the pernicious effects of arbitrage costs, I recommend sticking with funds that have liquid underlying holdings and consistent average daily trading volume. In addition, you should execute your trade using a limit order to ensure you receive a specific price instead of leaving the decision to an opportunistic market maker.
Many investors choose to have their portfolio managed by an investment adviser that may have a unique advantage in terms of asset allocation, service, or risk management. However, this will also add an additional layer of fees on your ETF portfolio as well. New automated online investment adviser services can help you streamline your portfolio using ETFs with limited interaction at a reduced cost.
By contrast, a traditional fee-only investment adviser may charge upwards of 0.75% per year to select investments on your behalf that conform to a specific model or style of investing. In addition, they typically offer personal service or enhanced planning to supplement their investment expertise.
All of these factors should be considered when weighing the costs of an adviser as a fiduciary for your assets.
The Bottom Line
On the surface ETFs seem like an easy choice to lower the cost of your portfolio versus a traditional mutual fund portfolio. However, it’s important to be wary of areas that can lead to higher than average fees that erode your returns.
A little research and planning can go a long way to providing peace of mind that your portfolio is positioned with the right mix of assets and lowest costs to suit your needs.