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Are ETFs the cheapest way to invest?


Dennis Mayer

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There’s a definite case to be made that exchange-traded funds, or ETFs, are extraordinarily cheap to own. For just $3 per $10,000 invested, you can own a piece of the top 3,500 large-, medium-, and small-cap companies in the U.S. with the iShares Core S&P Total U.S. Stock Market ETF (ITOT). In fact, there are currently over 30 ETFs with expense ratios of 0.05% ($5 per $10,000 invested) or less on the U.S. market. Before ETFs hit the market in 1993, such low expense ratios were unheard of in the mutual fund world, where fees of 2%, 3% or more weren’t uncommon. They’ve become incredibly popular since their introduction, and their low fees are exerting downward pressure on other types of mutual funds. It’s now possible to find traditional mutual funds and index funds with expense ratios well below 1%. But expense ratios are just part of the overall expense involved in trading and holding a fund. Because ETFs are traded on the exchange like a regular stock, you will always pay a commission when you buy or sell them. It is possible, however, to buy and sell certain index funds without a transaction fee. If you’re buying shares on a regular basis, your ETF trading costs could wipe out your gains, and you may be better off with a zero-transaction cost index fund. If you’re making one large purchase and plan to hold your shares for a long time, ETFs may well be cheaper. Because of their unique structure, ETFs tend to be far more tax efficient than index funds and other traditional mutual funds. Index and mutual fund managers need to make more frequent transactions to rebalance their portfolios, exposing you to capital gains taxes. ETFs mostly avoid these internal trades, reducing your potential for capital gains. There’s also the issue of bid-ask spread with ETFs. That can be significant in funds with low volume and poor liquidity. Index and mutual funds aren’t subject to spread, since they are priced once a day after the market closes. However, you can mitigate the effects of spread with ETFs by placing limit and stop orders. Dividends are another area that affect the overall cost of an ETF compared to an index fund. Index funds typically offer fee-free automatic dividend reinvestment, which means dividends are reinvested as soon as they are paid out—and index funds allow you to purchase fractional shares based on a fixed dollar amount. Some, although certainly not all, ETFs offer a dividend reinvestment program, but investors have to wait for the dividend funds to settle in their brokerage account before using them to purchase additional shares. These trades are not commission-free, and you can only buy whole shares in an ETF. There are behavioral issues which may also affect costs associated with ETFs. For example, index funds allow you to invest set dollar amounts each month; you can buy partial shares. ETFs require you to buy the entire share, so if you are allocating a set dollar amount to your investment account each month, you will always have some money left over as uninvested cash. Again, if you are paying commissions each month on your ETF trades, they will undoubtedly cost you more than buying commission-free index funds. The other behavioral risk is tied to the exchange-traded nature of ETFs. There is a temptation to trade more often in an attempt to “time” the market, which generally leads to more frequent trades, and higher overall commission charges. It’s really impossible to say whether or not ETFs will be the cheapest way for you to invest. It depends on your investment philosophy, trading patterns, and long-term investment goals.
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