Understanding ETF total cost of ownership

ETFs have become a popular investment choice due to their flexibility, low fees, and diversification*. 

When evaluating holding an ETF, however, investors must consider several critical factors. These include the investment objectives, the ETF’s exposure and structure, the liquidity of the underlying assets, and, importantly, the costs and fees that can affect the client’s investment returns over time.

How much does it cost for an investor to buy, hold, and sell an ETF?

This is an essential consideration for any investor deciding which investments fit better with their strategy and objective.

An ETF, much like a stock, can be bought and sold on an exchange throughout the trading day. Investors pay the ask price to buy the ETF and the bid price to sell the exposure. The bid-ask spread represents the transaction cost of trading in and out of the position. 

Several primary factors determinate the bid-ask spread’s width, including order flow volume, the amount of competition among market makers for any given ETF, and the associated costs of the primary market. Volatility and liquidity of the underlying assets can also influence an ETF’s bid-ask spread, with higher volatility or lower liquidity sometimes leading to wider spreads.   

The investor can consider the bid-ask spread as all-in cost to buy or sell an ETF. This is because the spread takes into account several implementation costs. Implementation costs include the primary market costs, custody fees, FX cost, potential market impact, hedging cost and taxes1.

Trading costs are not the only costs to be aware of, however. Investors should also consider the costs incurred while holding an ETF in their portfolio. The total cost of ownership (TCO) includes both trading and these holding costs.

One explicit holding cost is the Total Expense Ratio (TER), representing the annual cost of owning an ETF and expressed as a percentage of the fund’s assets. This includes management fees, administrative fees and other operating expenses. The TER provides investors with an understanding of ongoing costs. It doesn’t, however, provide a complete picture of the costs to hold an ETF over a time period (i.e., the holding costs). 

Let’s take, as an example, two funds that track the same index, where ETF A has a TER of 5 bps and ETF B at 10 bps. Just looking the TER, the investor’s choice might be to go for the first of these funds. However, by looking at the relative performance of both funds versus the index they track, we notice that while the index has performed 5% last year, ETF B returned 4.95% and ETF A just 4.9%. It appears then that ETF B has lower intrinsic costs and is therefore the better option. 

The tracking difference (TD) is the difference between the performance of the index and the performance of the ETF, which takes into account the TER. In this case ETF B has higher TER at 10 bps but with a lower TD at 5 bps.

The tracking difference is a better measure of the holding costs as it considers all costs (explicit and implicit) the investor incurs by holding the ETF. These include the TER, swap fees, rebalance costs, FX costs, stock lending revenues and taxes. 

Understanding the full cost of ownership is essential for investors aiming to make informed ETF investment decisions. By evaluating both trading and holding costs investors are better placed to select the product aligning with their financial goals and expected returns over time. 

 

*It should be noted that diversification is no guarantee against a loss in a declining market.

1Financial Transaction Tax or Stamp duty are not applicable to ETFs; however, it may apply to the underlying securities in the primary market.