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In general, ETFs are cheaper than mutual funds, but that doesn't mean they're free. In fact, some of the costs associated with ETFs don’t exist with traditional mutual funds. Before you buy, it pays to understand the true costs and how they could affect you.
Expense Ratios
Generally speaking, ETF expense ratios are lower than those of comparable mutual funds, because ETF providers don't take on the accounting in-house; nor do they include 12b-1 fees related to marketing costs, as mutual funds do.
Still, no matter how low an expense ratio is, it's still a drag on returns. Depending on their composition, liquidity and methodology, some ETFs will be more expensive than others. When you're faced with two funds tracking the same index, expense ratios might just be the deciding factor.
Commissions
In addition to trading like stocks, ETFs also carry trading commissions. The price per trade can vary by brokerage, account type, even how you order your trade (online, over the phone, etc.). Regardless, you're still subject to a flat fee with every buy and sell.
That means the normal investor modus operandi with mutual funds—small, frequent trades, usually as part of some payroll contribution—has to be rethought for ETFs.
Some brokerages, however, are waiving commissions for some or all ETF trades, as a way to entice customers in the growing competition over ETF market share. In general, however, ETF trades are still better suited for lump sum purchases, rather than bit-by-bit investing over a long period of time.
Bid/Ask Spreads
A fund's bid/ask spread is the gap between what traders are willing to pay and accept for a given ETF's shares. When trading an ETF, you purchase shares at some (higher) "ask" price, and sell them at a (discounted) "bid" price. Obviously, wider spreads will eat into returns.
For the largest, most well-traded ETFs, spreads are usually tiny (often just pennies). But for ETFs with lower assets or volume, the gap can be much wider.
Like commissions, spreads are more of a problem for frequent traders than buy-and-hold investors. But they can still wreak havoc on overall returns.
Investors should always use limit orders when trading to ensure they receive the best executions on their trades.
Premiums/Discounts
Sometimes in the course of normal trading, an ETF's market price can drift away from its net asset value, such that it's trading at either a premium (above) or discount (below) to its NAV.
Most of the time, ETFs trade with negligible premiums or discounts, as arbitrage (which we covered in our article about creation/redemption) helps to keep ETF prices in line with their NAVs. But sometimes, large premiums and discounts can emerge, and last for significant periods of time. These discrepancies usually result from some persistent illiquidity in the underlying securities—they are most often present in non-Treasury fixed-income ETFs—but they can also arise from outside pressures, such as when creations are halted due to regulatory scrutiny.
By themselves, premiums and discounts don't cost investors money, but changes in premiums and discounts can and do. For example, imagine you bought a bond ETF at a 1 percent premium to NAV, only to have that premium vanish by the time you sold the fund. That's 1 percent you will never recoup.
Of course, it's hard to completely avoid premiums and discounts. But it's still good to be aware of the risks involved.
Taxes
As discussed previously, most ETFs are more tax efficient than mutual funds, due to the inherent efficiencies of the creation/redemption mechanism. While mutual funds regularly make capital gains distributions to shareholders, the vast majority of ETFs have never made a capital gain distribution. In 2009, for instance, the ETF provider PowerShares paid out capital gains on just one of its 117 ETFs, covering equities, bonds, commodities and currency positions.
But not all ETFs are so tax efficient. Leveraged and inverse ETFs, for example, have paid out large capital gains distributions in the past. And capital gains distributions are only one piece of the tax puzzle.
One of the great things about ETFs is that they have opened up new asset classes like commodities and currencies to investors for the first time. But what some investors don’t understand is that these asset classes are taxed differently from traditional equities or bonds.
For example, physically backed commodity trusts like the $40+ billion SPDR Gold Shares (NYSEArca: GLD) are considered "collectibles," and are thus taxed at a 28 percent rate.
Futures-based ETFs like the U.S. Oil Fund (NYSEArca: USO) are taxed according to futures rates, meaning they’re subject to 60 percent long-term/40 percent short-term rates. What’s worse, gains are “marked to market” at the end of each year, meaning there is no way for investors to defer gains from year to year.
Currency-based products have the most negative tax treatment: For most currency ETFs, all gains are taxed as ordinary income regardless of holding period. If you buy the CurrencyShares Euro Trust (NYSEArca: FXE), any gains will be taxed as ordinary income, even if you hold it for years.
Taxes are complex, and can vary from situation to situation. But it's important to understand how these tax rates differ. As always, the best option is to consult a tax professional before you buy.
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