ETFs: How Much Do They Really Cost?

Exchange-traded funds (ETFs) are similar to mutual funds except that they trade intraday like stocks. Even though ETFs can be relatively inexpensive, investing in them does include 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 impact the total cost of ownership.

ETFs are popular with investors for a number of reasons, but investors often find the lower operating expenses most appealing. Most ETFs have low expenses compared to actively managed mutual funds.

ETF expenses are usually stated in terms of a fund’s OER. The expense ratio is an annual rate the fund (not your broker) charges on the total assets it holds to pay for portfolio management, administration, and other costs. 

As an ongoing expense, the OER is relevant for all investors but particularly for long-term, buy-and-hold investors.

When choosing between two or more ETFs that track the same market index (or similar indexes), be sure to compare their expense ratios among other factors. A little homework might pay off.

Today, many investors can trade listed ETFs online commission-free, including at Schwab.¹ 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

Let’s compare costs for two hypothetical ETFs assuming a $10,000 purchase.

At first glance, it would appear that 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 cost assuming you hold each ETF for one year, you pay zero commissions, and all other costs remain constant.

Furthermore, the 0.004% spread of ETF A also indicates that it likely has a higher trade volume than ETF B, which might make ETF A preferable for liquidity reasons as well.

The last (and possibly least understood) potential cost comes from changes in discounts and premiums to NAV during the period you hold an ETF. This potential cost differs from the others because it can be a positive factor on overall returns—for example, it might increase your return instead of decreasing it.

An ETF is said to be trading at a premium when its market price is higher than its NAV—simply stated, you're paying a bit more for the ETF than its holdings are actually worth. An ETF is said to be trading at a discount when its market price is lower than its NAV—that is, you're buying the ETF for less than the value of its holdings.

For example, imagine an ETF that trades in the market at $30 per share. If the individual stocks the ETF holds are worth only $29.90 per fund share, then the ETF is trading at a premium of 0.33%. Conversely, if the stocks the ETF holds are worth $30.25 per fund share, the ETF is trading at a discount of 0.83%.

In general, most ETFs exhibit small discounts and premiums. When material differences do manifest in ETF prices, large institutional investors (called authorized participants) usually help the market self-correct by attempting to profit from arbitrage trades that serve to better align an ETF's market price and NAV.

To illustrate this point, let's assume an ETF is trading at a premium of 1% to NAV. An authorized participant might attempt to capture that premium by simultaneously purchasing a basket of the underlying securities the ETF tracks, exchanging the basket of securities for shares of the ETF, and selling the shares in the open market.

This process of exchanging baskets of the securities in an index for shares of the ETF is called the in-kind creation/redemption mechanism, and it's the reason ETF premiums and discounts are generally self-correcting. 

Deviations from NAV create profit opportunities for authorized participants. As they conduct arbitrage trades, they help bring the ETF's market price into better alignment with its NAV.

In the case of an ETF that trades at a premium, for example, authorized participants selling newly created ETF shares increase the supply in the market, which helps drive down the price of the ETF closer to its NAV.

When the securities that make up the index an ETF tracks are easily priced because many buy and sell orders are being placed in a centralized exchange, "creating" a basket of securities to replicate the index is relatively straightforward.

As a result, ETFs that track heavily traded, highly liquid markets—like U.S. stocks—typically display only small premiums or discounts. A good example of this is an ETF that tracks the S&P 500^® and whose market price might not stray more than 0.20% or so away from its NAV.

However, ETFs that track less liquid markets—such as high-yield bonds, commodities, or emerging markets—can display differences of 1% or more, usually due to lack of liquidity but sometimes because of more complex factors.

You can tell if an ETF is trading at a premium or discount by checking its performance using Schwab's ETF quotes and research tool, where you can find the premium or discount as a percentage of NAV for the previous day's close.

Remember, the change in discount or premium is what matters most. Moreover, these changes aren't always necessarily a drag on performance—the effect can be either positive or negative depending on which way the discount or premium moves between a purchase and subsequent sale.

For example, if an international fixed income ETF trades with a somewhat persistent 0.6% premium to NAV, and you bought and sold the ETF at that same premium, your return wouldn't be affected.

The risk comes when that premium erodes or even becomes a discount during the time you own it. In our example, if you bought the ETF while it was trading at a 0.6% premium but sold it while it was trading at a 0.4% discount, the change during the roundtrip would've cost you 1%.

Although realizing small gains or losses from potential changes in discounts and premiums might be acceptable in many cases, and possibly even unavoidable for certain ETFs, the main point is to be aware of the risks involved—and to be purposeful when trading ETFs that may exhibit excessively large or volatile discounts and premiums to NAV.

Investors should also be aware that some investment products, such as exchange-traded notes (ETNs) and closed-end funds, also trade intraday like stocks and ETFs. However, because these products lack the complete in-kind creation and redemption process used by ETFs, discounts and premiums may be more problematic.

Your portfolio strategy greatly influences the net effect of commissions, operating expenses, bid/ask spreads, and potential changes in premiums and discounts to NAV.

In the table below, we estimate the hypothetical cost of ownership for a long-term, buy-and-hold investor and an active investor who both invest in the same ETF.

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 the 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. 

In conclusion, investors should remember that key considerations of an ETF's total cost of ownership includes a combination of its operating expenses and costs of trading. Your investing strategy as well as the specific ETFs that you select for your portfolio can make a big difference in the total cost.²