Low-cost ETFs: what you need to know
Low-cost ETFs are a popular choice for many investors. In this article, you’ll learn the benefits of investing in low-fee Exchanged Traded Funds, what makes a good one, and how to tell if an ETF is low-cost or not.
What is an ETF?
To offer a simple definition, an ETF, or Exchange Traded Fund, is a basket of securities, whether they be stocks, bonds, futures, or any other publicly traded asset. It is common practice that the ETF is bundled into a wrapper managed by an Authorized Participant who governs the buying and selling of units. You buy or sell shares just as you would a stock on any exchange. Many ETFs mimic an index and are referred to by the term “index funds.”
Why invest in ETFs?
As a financial advisor in Philadelphia, PA it is beyond the scope of this article to elaborate further on each of these; but as outlined in our overview of Exchange Traded Funds, the advantages of investing in ETFs are:
- Flexibility
- Diversification
- Tax efficiency
- Lower cost
As high fees and high cost of investment can significantly reduce an investor’s wealth when compounded over time, we will focus on low-cost ETFs for the remainder of this article.
Do ETFs have low fees?
Yes.
Usually, ETFS are usually low-cost investments. They are created with the intent to mirror the performance of a benchmark. This is called passive management. For this reason, Exchange Traded Funds generally have lower fees than mutual funds or actively-managed vehicles.
Low-cost investing is important. The impact of fees compounded, year after year, can be quite detrimental to the building of wealth. Assume you were to hypothetically have $100,000 invested.
- If the account earned 6% a year for the next 25 years and had no costs or fees, you'd end up with about $430,000.
- If, on the other hand, you paid 2% a year in costs, after 25 years you'd only have about $260,000.
That's right: The 2% you paid every year would wipe out almost 40% of your final account value. 2% doesn't sound so small anymore, does it?
It’s pretty clear that the cost of investment is not something you should overlook. There is potential for low-cost ETFs to reduce this effect; but first, let’s understand the costs that come with investing in ETFs.
What does it cost to invest in an ETF?
Although there are several low-cost ETFs, there are no free ETFs. However, some of the largest and most popular ETFs are about 3 - 4 basis points (0.03%-0.04% of assets invested). They are nearly free. The ETF’s cost is listed is its prospectus as well as the fund sponsor’s website.
Here are the major expenses that you pay when you own an ETF:
- You will pay an administrative expense, as reflected in the fund’s expense ratio, that indicates the cost to manage the fund as well as other miscellaneous costs. This is paid to the fund sponsor.
- You might pay any commissions incurred when you buy or sell it. Most brokerage firms do not charge them, but there may be commissions for certain types of trades (foreign stocks, options, etc.).
- You will also pay any tax on capital gains when you sell. In the United States, this is paid to Federal, state, and local government entities.
There are also implicit costs such as the bid-ask spread. Whenever an ETF is traded, there is a buyer and seller who are party to the transaction. The price at which the buyer is willing to purchase is called the “bid” and the price at which the seller is willing to sell is the “ask.” The difference is called the spread. Wide bid ask spreads can drive up the price for buyers or lead the seller to fail to capture the highest price.
ETFs vs. Mutual Funds – which one is more expensive?
While every case is different, Exchange Traded Funds are generally less expensive than investing in an actively managed fund, in which the portfolio manager invests to outperform the benchmark. Because of the cost of research, technology, and human capital, actively managed funds tend to come with a higher cost than passively managed funds.
Mutual funds may also track an index, but they are generally not low-cost index funds as they would be if they were an ETF.
What is considered a low-fee ETF?
Now that we’ve covered the benefits of investing in a low-cost ETF, how do you know what is actually considered a low fee?
According to the 2019 Investment Company Fact Book, the asset-weighted average expense ratio for index equity ETFs (the average shareholders actually paid) was 0.20%. The asset-weighted average expense ratio for index bond ETFs was 0.16%. For some time, ETF expense ratios have been on a constant trend downwards, and as of the time of this writing it is possible the current fees are even lower than their 2019 levels.
While ETFs that fall within this range may generally be considered low-cost, it is important to consider the overall the wealth impact of owning any particular ETF. Not all low-cost ETFs are made equal.
How do you find a good one?
How to pick a good cheap ETF: five steps
Here are five steps to take if you are looking to pick a good low-cost ETF for your portfolio. Before we get into this discussion, we wanted to remind you that this is not a recommendation of any one particular investment or strategy. Nothing in this article may be interpreted as financial advice specific to any one individual. For such advice, consult a wealth manager.
#1 Create an overall strategy
Why wouldn’t you just pick the lowest of all the low-cost Exchange Traded Funds and call it a day? Are low-cost investments actually better?
It’s not quite that simple as finding the ETF with the lowest fees.
Buying an ETF without considering the overall purpose of the instrument doesn’t make sense. Any investment strategy should be matched to the risk tolerance of the investor. There should be some idea of the mix of asset classes (stocks, bonds, etc.) and how this overall asset allocation meets your objectives.
#2 Assess the purpose of the ETF
Once you have your strategy in place, think about what you need the ETF to actually do.
Here’s an example.
Let’s say your investment strategy calls for an exposure to bonds, ETFs can be used to manage the overall interest rate sensitivity, or duration, of your collective bond position. Owning the bonds through ETFs allows the overall exposure to be adjusted as rates rise or fall.
Knowing this you would look for certain types of bond ETFs (funds tracking one particular index vs. another) and rule others out.
#3 Assess liquidity
Liquidity is important to consider because wide spreads (remember the bid-ask spread we described earlier?) can drive up the cost of buying shares and/or drive down the price you get when redeeming shares.
Liquidity comes in two parts for an ETF: the liquidity of the ETF shares trading on the exchange, and the liquidity of the underlying securities in the basket. You should be wary of ETFs that invest in less liquid instruments such a real estate.
- If an ETF trades in securities that are hard to buy and sell, it may be hard for the Authorized Participant to create or redeem shares, which then in turn makes it harder to affect transactions, especially for a large amount of shares.
- The shares outstanding for an ETF represents the number of issued shares. Potentially all of these shares could be bought and sold at any one given time. It’s important that there are sufficient shares ready to be traded, because if not then there is potential for large supply or demand imbalances to result which can alter the bid/ask spread, ultimately impacting the price you buy or sell the shares for.
#4 Consider its assets
If an ETF is so small (in terms of assets) that isn’t very liquid, there is a risk that the bid-ask spread will be wide. There is no set rule as to how big an ETF should be in terms of the assets under management; many factors come into play. We generally only consider ETFs with assets above $1 billion.
#5 Consider the underlying index and the tracking error against it
Two ETFs may track the same index, but their performance may differ greatly. Funds that do not closely follow the index may include a higher degree of active management, which may be problematic if you are counting on that ETF to fulfill the purpose you identified in step #2.
Did we convince you of the merits of low-cost index funds?
Finding the best low-cost Exchange Traded Funds for the long term is a much more involved task than we’ve delved into in this article. On top of all the factors mentioned here that you need to take into account, remember that everything changes with time. Today’s ETFs may not be the best cheap ETFs to buy in 2023 or beyond.
We are a financial advisor in the Philadelphia, PA area, but we work with clients across the country. We provide fee-only, objective advice to our clients. We carry out our investment strategies using low-cost ETFs for our clients. If you would like to discuss a possible relationship, contact us.
Sources
Investment Company Institute. 2019 Investment Company Fact Book: 59th edition. Retrieved from https://www.ici.org/system/files/attachments/pdf/2019_factbook.pdf
Vanguard. Don't let high costs eat away your returns. https://investor.vanguard.com/investing/how-to-invest/impact-of-costs