An Exchange-Traded Fund (ETF) is a financial instrument that tracks indices or a unique set of stocks in different sectors. ETFs are traded on exchanges just like company stocks, both during regular trading hours and in extended trading sessions.
ETFs are usually managed independently and firms charge a small yearly fee for operating them. These expenses include costs like portfolio management, administration, marketing, and distribution fees. An ETF’s expense ratio reflects these costs.
ETF Expense Ratio
An ETF’s expense ratio will define what percentage of your investment into the fund will be deducted annually. Usually, an ETF’s expense ratio is below 1%, which is lower than those charged by mutual funds.
An ETFs’ Expense Ratio is defined as the fund’s operating expenses divided by the average assets of the fund.
Expense Ratio = Operating Expenses
Average Assets
Here’s an example of how funds compute the expense ratio. If a fund has $1 billion in assets under management and it costs $1 million per year to operate and manage the fund, the expense ratio is:
$1 million/$1 billion = 0.01
This number, converted into percentage terms, yields 1%. This means that each year 1% of your fund’s investment value will go to the fund company to manage the ETF. This implies that you will end up paying roughly $10 for every $1,000 worth of investments annually.
This ratio is important from a long-term perspective, as every dollar that is deducted from your investment annually will not compound over time. Hence, the lower the ETF expense ratio, the better it is. An investor must choose wisely when deciding which ETF to invest in, and choosing an ETF with a lower expense ratio could be a good start.
What are the Components of an Expense Ratio?
After a basic understanding of the expense ratio, let us look at the three categories of expenses included in the calculation.
# Management Fees – Management fees are paid to the persons/managers actively operating a particular fund. This fee will depend on whether the fund is actively managed or passively managed, with active funds charging a higher fee.
# Custodial Fees – As the name suggests, custodial fees are charged for safeguarding a customer’s funds. Generally speaking, custodial fees are used to keep the funds safe from being lost or stolen.
# Other Expenses – While it is difficult to understand what expenses are included in this category, they may include other marketing and administration-related expenses of a fund.
Other Costs to Consider While Investing in ETFs
Apart from the expenses included in the expense ratio, an investor will also have to bear two main types of costs while investing in ETFs: Brokerage Commission and Bid/Ask Spread.
# Brokerage Commission – Brokers usually charge a commission for making trades on behalf of an investor. Importantly, over the years, this cost has reduced drastically, and most listed ETFs can now be traded commission-free.
However, if your broker is charging you a fee for trading, it may be worth noting that the commission is mostly in terms of a fixed dollar cost rather than a percentage of the trade. In effect, the commission will be higher if you trade more frequently. Plus, brokerage commissions become expensive on smaller trade amounts as it is a fixed dollar cost.
For example, a commission of $2 on a $200 trade implies a bigger 1% fee, whereas the same $2 commission on a $1,000 trade implies a 0.2% fee.
# Bid/Ask Spreads – A “bid” is the price at which an ETF can be sold, and an “Ask” is the price at which an ETF can be bought. A “Spread” is the difference between these two prices. In the case of ETFs, the bid/ask spread is usually built into the market price of the trade and is paid each time you buy and sell the ETF. Hence, the larger the spread and frequency of trading, the higher this cost becomes.
The forces driving the gap between the bid and ask prices of an ETF include the liquidity of the ETF (underlying assets), the performance of the ETF, the costs of managing the ETF, and general market risks.
Key Takeaways
Investing in an ETF has caught a lot of attention lately. Individuals are happy to put their investible corpus in ETFs as they give them the benefits of diversification, lower costs, higher liquidity, flexibility, transparency, and tax efficiency. Moreover, individuals do not have to worry about choosing stocks and actively managing their portfolios.
Finally, before selecting the ETF, investors must look at all three types of costs associated with ETFs. A comparative study of different ETFs will improve your understanding of the costs and help you choose the one with the lowest costs and most favorable returns.
Investors can use the TipRanks ETF page to research and study their performances and make informed investment decisions.
