ETFs: How Much Do They Really Cost?

Even though exchange-traded funds (ETFs) can be relatively inexpensive, investing in them includes certain costs. The most obvious is the operating expense ratio (OER), which is incurred while owning the ETF. However, trading costs are also important: Commissions (if applicable), bid/ask spreads, and changes in discounts and premiums to an ETF's net asset value (NAV) will all impact the total cost of ownership.

Ahead, we'll look at ETFs' expense ratios and other trading costs. Investors should consider the impact that these costs and expenses will have on their returns. ETFs with lower expense ratios and lower trading costs typically offer better value to investors, because higher expense ratios and/or steeper trading costs may significantly erode returns over time.

An ETF's operating expense ratio is the annual rate that the fund (not your brokerage) charges on the total assets it holds to pay for portfolio management, administration, and other costs. As an ongoing expense, the operating expense ratio is relevant for all investors but particularly for long-term, buy-and-hold investors.

Most passively managed ETFs have lower expense ratios than actively managed mutual funds, but not all ETFs are friendly when it comes to fees. While the lowest-cost ETFs tend to have expense ratios less than 0.10%, the highest cost ETFs have expense ratios exceeding 10%. That's a difference of 100x.

When selecting an ETF, be sure to compare its expense ratio to the expense ratio of other funds, especially funds that track the same market index or provide exposure to the same type of assets (while also considering other factors).

An expense ratio tells you what percentage of an ETF's total assets are being used to cover its annual operating expenses. Think of an expense ratio as the cost of doing business, which is then passed on to investors.

The expense ratio is calculated by dividing a fund's total costs by its total assets. The expense ratio is usually stated as a percentage but is sometimes reported in basis points (or bps), which are simply 1/100 of 1% or 0.01%. ETF expense ratios accrue daily and are subtracted each day from an ETF's assets. This happens when the manager calculates the daily net asset value, or NAV, at the end of the trading day.

Expense ratios can vary widely. For example, if you look at a number of different funds, you may find expense ratios ranging from 0.03% (or even lower) to around 1.5% (or even higher). Some ETFs have expense ratios exceeding 10%.

The lowest-cost ETFs tend to track well-known broad-based indexes, such as the S&P 500^®. Higher-cost ETFs tend to be actively managed, track more complicated indexes, or provide exposure to an index or single stock that is either inverse or leveraged. Additionally, some higher-cost ETFs make investments in cryptocurrencies, business development companies (BDCs), and other ETFs or mutual funds (these are known as fund-of-funds). Alternatively, higher-cost ETFs may invest in strategies that provide exposure to derivatives (including futures, options, and swaps).

However, even small expense ratios can add-up over time, as shown in this investment fees calculator. Imagine investing $100,000 into a fund that generates 4% in annual returns over a 20-year period. With no costs and fees, you may end up with a little more than $219,000. With a middle-of-the-road expense ratio of 0.5%, your end result could be around $20,000 lower, not counting other costs and fees. And with a 1.5% expense ratio, your returns may be reduced by a little more than $55,000, again, not counting other costs and fees. The range and impact of expense ratios can be significant to your total return.

An ETF's expense ratio covers the fund's total annual operating expenses, which include management, marketing, and distribution fees. Also included may be fees for accounting, administration, recordkeeping, custodial services, and legal services. ETFs that hold other ETFs, mutual funds, or BDCs tend to have higher expense ratios, as these "acquired fund fees and expenses" are also reflected in the expense ratio. 

Some ETF issuers may provide fee waivers on certain ETFs. These reduce the ETF's expense ratio for a set period of time or until an ETF reaches a particular asset threshold. Details about fee waivers can be found in the fund's prospectus. ETFs with waivers will report both "gross" and "net" operating expense ratios. The gross OER is the higher fee that investors should be prepared to accept when the fee waiver expires.

It takes a lot to manage a fund, and some funds may require more services and incur higher costs than others. This is why expense ratios vary from fund to fund. But remember, ETF expense ratios are only one dimension to consider when assessing funds. A fund with a 0.00% expense ratio may be too good to be true if the fund sponsor doesn't have the resources to adequately support the fund and it ends up shutting down or raising its expense ratio in the future.

Typically, ETFs have lower expense ratios than mutual funds. Generally, low-cost equity ETFs will have a net expense ratio of no more than 0.25%. Low-cost equity mutual funds will have expense ratios of 0.5% or lower. Low-cost bond ETFs often have expense ratios under 0.2%, while low-cost bond mutual funds typically have an expense ratio of 0.4% or lower.

Today, many investors can trade listed ETFs online commission-free, including at Schwab. Thus, commission costs aren't as important of a consideration as they have been in the past. However, you'll still want to know what your broker charges for trade commissions, which can range from $0 to $25 or more (fees are often higher if you place a trade in person or over the phone). 

In cases where you pay commissions to trade ETFs, keep these two points in mind:

• The more frequently you trade, the more you'll pay in total commissions.
• Because commissions are typically a flat fee no matter how large or small the trade, the percentage cost per trade will be larger for smaller trades and smaller for larger trades. For example, a $5 commission on a $500 trade represents a somewhat large 1% fee, whereas the same commission paid on a $5,000 trade represents a 0.1% fee.

While commissions and expense ratios are straightforward, ETF investors often overlook a third cost: the bid/ask spread.

The ask (or offer) is the market price at which an ETF can be bought by an investor, and the bid is the market price at which the same ETF can be sold. The difference between these two prices is commonly known as the bid/ask spread. 

You can think of the bid/ask spread as a transaction cost similar to commissions except that the spread is built into the market price and is paid during the purchase and sale. So, the larger the spread and the more frequently you trade, the more relevant this cost becomes.

The three main factors that drive bid/ask spreads include:

• The extent of market maker competition
• The liquidity of the underlying assets in the ETF
• Market maker inventory management costs

At first glance, it would appear ETF B is less expensive because of its lower expense ratio.

After closer examination of the bid/ask spreads, however, you learn that ETF B has a much larger spread than ETF A. This tells you that in a roundtrip trade, you're estimated to lose more of your investment in ETF B than ETF A because of the difference in spreads.

Despite its higher expense ratio, ETF A looks to have a lower total cost, assuming you hold each ETF for one year, pay zero commissions, and all other costs remain constant.

The more you trade, the more important commissions and bid/ask spreads become, because you pay for each during every roundtrip made. On the other hand, the longer you hold an ETF position, the more important its expense ratio becomes because it's a recurring management fee paid to the fund for as long as you own the ETF. 

Discounts and premiums to NAV can either drag or boost performance depending on how they move during the time you hold the ETF.