Don't Ignore Costs Of ETFs

4/18/2011


 

Frugal investors have flocked to exchange-traded funds (ETFs), partly because of their low expense ratios. But there is more to ETF expenses than meets the eye, as a variety of costs can eat into returns:

Commissions. Typically, you must pay a commission if you buy or sell an ETF. Thus, the funds may not be suitable for systematic trading, such as dollar-cost averaging strategies. Some brokers waive commissions on select funds, including TD Ameritrade (roughly 100 commission-free ETFs), Fidelity (30), Charles Schwab (13), and Vanguard (49).

Expense ratios. All things equal, the lower the expense ratio, the lower the cost of owning an ETF. Hailed for their rock-bottom fees, not all ETFs are bargains — some expense ratios exceed 1.80%. On average, large-company U.S. stock ETFs have an expense ratio of 0.43%, versus 0.46% for midcap ETFs and 0.43% for small-cap ETFs.

Premiums and discounts. ETFs have two important values: The market value is the price at which investors buy and sell shares, while net asset value (NAV) captures the underlying value of the securities in a portfolio. ETFs are not always bought and sold at prices equal to NAV, but the differences for most funds have historically been small. Still, buying an ETF at a premium means overpaying for the basket of securities. If the premium erodes or becomes a discount, the market-price return will dip below the NAV return.

Bid-ask spreads. Like stocks, ETFs trade using two prices — bid and ask. For example, the SPDR S&P 500 (SPY) recently traded with an ask (purchase price) of $131.70 and bid (sell price) of $131.69, putting the spread at $0.01. The spread reflects a fund's asset level, trading volume, and the liquidity of its holdings, as well as the actions of the market makers expected to maintain efficient trading.

Many ETFs trade with only marginal bid-ask spreads, but some have a sizable gap. For example, in March, Vanguard Mortgage-Backed Securities (VMBS) had an average bid-ask spread of $0.21, or 0.42% of its average daily price. Assuming the spread of 0.42% is fairly steady over 12 months, an investor selling the ETF after one year (while absorbing its 0.15% annual expense ratio) would have incurred an implied cost of ownership of roughly 0.57%.

 

FORECASTS FUND RECOMMENDATIONS
Through Apr. 12, our recommended Growth Portfolio has returned 4.6% for the year, versus 5.0% for its benchmark portfolio. The Conservative Portfolio has returned 1.0%, versus 3.9% for its benchmark.
— Year-to-Date —
—– % of Portfolio –—
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
American Century Heritage
($22; TWHIX)
1.5
D
9
10
69
Buffalo Growth
($26; BUFGX)
3.8
C
9
10
94
Dreyfus MidCap Index
($30; PESPX)
7.2
B
0
0
94
Dreyfus Small Cap Stock Index
($21; DISSX)
5.1
C
0
0
53
Heartland Select Value
($31; HRSVX)
5.3
D
7
10
77
Heartland Value Plus
($31; HRVIX)
4.2
C
9
10
98
T. Rowe Price Int'l Discovery
($45; PRIDX)
2.6
C
5
6
35
T. Rowe Price New Horizons
($36; PRNHX)
8.7
A
9
10
96
Vanguard 500 Index
($121; VFINX)
5.0
B
5
5
62
Vanguard Dividend Growth
($15; VDIGX)
5.3
B
8
9
91
Vanguard Emerging Mkts.
Stock Indx. ($31; VEIEX)
2.3
B
0
5
91
Vanguard GNMA ($11; VFIIX)
0.7
A
4
0
93
Vanguard Inter.-Term Tax
Exempt ($13; VWITX)
0.5
B
0
0
78
Vanguard International Value
($33; VTRIX)
2.5
E
8
6
60
Vanguard Short-Term Invest.
Grade ($11; VFSTX)
0.9
B
0
0
76
Vanguard Total Bond Mkt. Index ($11; VBMFX)
0.4
E
12
0
51
Vanguard Total Int'l Stock
Index ($16; VGTSX)
3.6
C
6
6
86
Vanguard Wellesley Income
($22; VWINX)
2.7
C
0
0
95
Vanguard Wellington
($32; VWELX)
4.1
A
5
8
77
Wells Fargo Advantage High
Income ($8; STHYX)
4.5
B
4
5
73
* Year-to-date ranks through Apr. 12 from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. Fund ratings are percentile ranks based on our fund-rating system.

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