Retail investors, big institutions, and the companies that serve them can’t get enough of exchange-traded funds (ETFs). These securities combine the diversity of a mutual fund with the flexibility and minute-to-minute (or, really, second-to-second) pricing of a stock.
An ETF references a list of securities, and its value is reflective of the value of the securities it holds. While this set-up is similar to that of a mutual fund, ETFs allow for diversity and ease of use for individual and institutional investors that’s unique. And, for the most part, they’re cheaper.
Quick ETF Crash Course
An exchange-traded fund is a collection of dozens or even hundreds of securities such as stocks or bonds, that give an investor access to different markets with a few clicks of a button. While this may sound similar to a mutual fund, one big difference is that ETFs are traded on a stock exchange, whereas mutual funds are traded once a day, after markets close.
As of December 2020, there were over $6 trillion of assets invested in ETFs and related products with over $500 billion worth of new money flowing into them last year. Some of the largest ETFs, reflect large swathes of the market as a whole, similar to index mutual funds (though there are some differences between the two funds—learn more about ETFs vs index funds).
ETFs can reflect the judgment of portfolio managers, or formulas investment companies come up with to select stocks or other assets with certain characteristics that make sense in a portfolio. There are also ETFs for commodities and leveraged ETFs that can magnify gains—or losses.
When it comes to comparing one ETF to another or comparing ETFs to other comparable investments, it’s always a good idea to have a sense of ETF fees.
How are ETF Fees Calculated?
When it comes to calculating the cost of owning an ETF, an investor needs to factor in not just management fees and expense ratios, but also the fees associated with trading the ETFs, like a broker’s commission. Because they are typically passively managed and based on market index, ETFs tend to have low overall fees as compared to mutual funds.
ETF Management Fees
ETFs carry management fees, which tend to cover the technical and intellectual work involved in selecting and managing assets in an ETF.
When you look up the fees of a given ETF, they are shown as a percentage of the ETFs daily assets. One benefit of many ETFs that’s reflected in their low management fees is the lack of what’s known as “management risk”—i.e. the potential losses that may be incurred if a key person or group of people is no longer involved with that particular fund.
The ETF Expense Ratio
The overall set of fees for an ETF is known as the expense ratio or the ETF expense ratio. ETFs typically have an expense ratio of 0.05% to about 1%.
An investor can determine the expense ratio by dividing the annual expenses of the investment by the fund’s total value, though the expense ratio is also typically found on the fund’s website. Knowing the expense ratio will help an investor understand exactly how much money they will spend investing in an ETF fund annually.
For example, if an investor puts $1,000 into an ETF that has an expense ratio of 0.2%, they will pay $20 in fees every year.
ETF Commission Fees
One benefit of ETFs is that you can trade them like any other asset you buy or sell on an exchange, such as a stock or a bond. But as with those assets, investors may be charged a commission when buying and selling ETFs.
Some brokers no longer charge commissions or specifically offer commission-free ETFs. But the availability of these depends on both the ETFs “sponsor” and the brokerage or platform used to buy and sell the funds.
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How are ETF Fees Deducted?
ETF fees are calculated as a percent of the ETFs net asset value, averaged out over a year. These ETF fees are not paid directly—you don’t write a check to the ETF sponsor to pay the management fees. Instead they’re deducted from the Net Asset Value of the fund itself, taken directly from returns that could otherwise go to the investor.
The SEC offers an example of just how important fees are: “if an investor invested $10,000 in a fund that produced a 5% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years the investor could have roughly $19,612. But if the fund had expenses of only 0.5%, then the investor would end up with $24,002—a 23% difference.”
ETF Fees vs. Mutual Fund Fees
One fee advantage ETFs have over mutual funds is that ETFs don’t have a front-end load fee. This is an expense associated with the selling of mutual funds that incentivizes brokers to sell one over the other.
Generally speaking, both ETF fees and mutual fund fees have been dropping in recent years as investors move to more passive strategies and providers of these productions compete on providing the lowest cost investment.
That said, though there are exceptions, ETFs tend to be more passive and thus have lower funds. They also don’t have some of the sales costs associated with mutual funds and their intensive marketing apparatuses.
If an ETF tracks an index, buyers can easily compare one provider’s fund to another and select the one with the lowest fee. This process can drive management fees and charges down as providers compete for business.
ETF fees can be relatively low compared to mutual funds, but as with any investment fees, it’s good to know the potential costs upfront. Knowing an ETF expense ratio can go a long way toward helping an investor understand their total costs for investing in the fund.
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