The most important cost for an ETF investor is not the management expense ratio or the total expense ratio (refer to ETF Costs article for more information about these ratios) but the total portfolio cost of owning an ETF.
Whilst Exchange-traded funds (ETFs) are world renowned for their rock bottom fees, an ETF’s annual expense ratio is not the only cost.
Nor does every investor, even those who own the same exact fund, pay the identical cost.
There are 5 main levels of costs of owning an ETF, which are as follows:
Management Expense Ratio (or Operating Expense Ratio)
Other Fund Expenses (such as expense recovery’s)
Transaction costs within the fund (brokerage commissions, bid/ask spreads) which are not included in points 1. or 2. above
Hidden fund costs (refer to ETF Costs article for more information)
Investor level costs such as transactions costs, bid/ask spreads taxation etc
Let’s analyze these five inputs to calculate an investors total portfolio cost:-
Management Expense Ratio (MER) and other Fund Expenses (1. and 2. above)
Management expenses and some other fund expenses are disclosed in the prospectus. The expense ratio is the ongoing management fee or cost that an ETF charges to shareholders for managing the ETF’s investments.
Unfortunately investors are never going to know 3. and 4. above so they won’t really be able to assess the level of these costs.
Bid/Ask Spreads (5. above)
The bid/ask spread is the difference between the lowest seller’s ask price and the highest buyer’s bid price (refer to this article How to buy ETF’s). Generally, ETFs with large daily volume like the iShares MSCI Australia 200 (IOZ) will have tighter bid/ask spreads compared to those ETFs with lower volume. For active ETF traders the cost of bid/ask spreads can be more significant than OER.
To calculate the bid ask spread percentage follow these steps:-
1. Subtract the bid price from the ask price (for example $40.55-$40.65=0.10 cents)
2. Divide the spread amount by the ask price (for example $0.10 cents/$40.65 = 0.25%)
Brokerage Commissions (5. above)
You will pay a transaction fee or commission for each trade placed and these costs chew into your returns more significantly than most investors realise.
How do I Calculate the Total Portfolio ETF Cost?
Here’s an example
For an ETF with an OER of 0.19%, a bid/ask spread of 0.25%, a one year holding period, an $24.95 trading fee and a $10,000 investment, the annual total cost of ownership is 0.69% per year.
Here’s the calculation:
0.69% total per year
This might not seem that bad at first brush, but remember if the ETF’s return is 5% for the year, nearly 14% of your return is gone before you started (0.69%/5%=13.9%). Refer to Why Do ETF Costs Matter article for a real world example.