While everyone can just sit back and enjoy the expense ratio cuts as the result of the so-called fee war, investors should still be wary of other costs to trading exchange traded funds.
Expense ratios are not the only costs associated with ETF investments. Bid-ask spreads – the price difference between the buying price and the selling price – and commission fees are just some other factors to consider.
The bid-ask spread is found by taking the bid subtracted from the ask, divided by the share price and multiplying by 100. [Bid-Ask Spread]
“The ETF expense ratio is an ongoing annual charge, whereas the bid-ask spread and commission costs are at the time of a transaction,” Joel Dickson, senior ETF strategist at Vanguard , said in a Wall Street Journal article. [Video: Vanguard's Joel Dickson]
Michael Iachini, managing director of ETF research for Charles Schwab Investment Advisory Inc., though, has offered a simple formula to convert expense ratios, bid-ask spreads and commission fees to a single per-year percentage expense:
- First off, the expense ratio remains as a percentage.
- The per-year, bid-ask spread percentage is calculated by dividing the current spread with the holding period. For instance, if an investor holds a fund for half a year, the spread is divided by 0.5, and if the fund is held for 2 years, divide by 2.
- Lastly, the commission is taken out whenever you buy or sell a fund, unless the brokerage offers commission free trades. The commission per-year percentage conversion is taken by multiplying the commission fee by 2, divided by the total dollar amount invested and then multiplying by 100.
- ETF investors can then add up the three numbers to calculate the total annual cost in percent terms.
Since the calculations are based on a time component, the total cost for long-term holders will inevitably be lower than for short-term traders.
Additionally, potential investors should be aware of other implicit costs, like premiums or discounts to underlying holdings, that may hurt or help performance. [Premiums and Discounts]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.