top of page
  • Facebook
  • Instagram
  • Twitter
  • TikTok

Should we know the exact total cost of ETF ownership?

Investing in Exchange-Traded Funds (ETFs) has become a popular choice among individual investors in recent years. They offer an easy, cost-effective way to invest in a diverse range of assets, and they are becoming increasingly popular as more people incorporate ETFs into their portfolios. However, an investor should also know the costs of investing in ETFs.


One of the most known costs is the expense ratio. ETFs charge an expense ratio to cover their total annual operating expenses such as administrative and marketing costs. The expense ratio is expressed as a percentage of a fund's average net assets. The lower the expense ratio, the better, which means that you will pay less for the ETF in the long run.


But besides the expense ratio, what are the other costs associated with ETF ownership and should we know the exact total cost of ETF ownership?


There are many ways to categorise these ETF costs and here are some ways:

  • Internal vs external cost

  • Implicit and explicit cost

  • Direct and indirect cost

Whatever you want to categorise it, the following are some of the other costs that make up the total cost of ETF ownership.



Commission:

The commission is the fee you pay your broker for executing ETF purchases or sales. The commission varies depending on the broker, and it is worth shopping around to find one that offers low commission fees.


Taxes:

In general, there are two types of ETF investing taxes: capital gains tax and dividend tax. The amount of tax you will pay will depend on your country of residence and the type of account you use to invest. It is important to understand the tax implications of investing in ETFs in your jurisdiction to minimise the tax burden on your returns.


Bid-Ask Spread:

The bid-ask spread is the difference between the price a buyer is willing to pay for ETF shares (the bid price) and the price at which a seller is willing to sell (the ask price). If the spread is wide, it means that the buyer will have to pay more for each share and the seller will receive less for each share. This difference between the bid and ask price is the cost incurred by investors when they buy or sell ETF shares, which is why it is considered a part of the total cost of ETF ownership. A wider bid-ask spread can therefore increase the cost of buying or selling ETF shares and impact the overall cost of ETF ownership.


Should we know the exact total cost of ETF ownership? | The Globetrotting Investor | Value Investing
Source: Flowbank

ETF Tracking Error:

ETF tracking error is a measure of the difference between an ETF's Net Asset Value (NAV) total return and the total return of the underlying index. It represents how closely the ETF tracks the performance of the index it is designed to follow.


A low tracking error indicates that the ETF is closely following the performance of the underlying index, while a high tracking error indicates that the ETF is deviating significantly from the index. Henceforth, the smaller the ETF tracking error, the better, as it means that the ETF is tracking the index more closely.


Turnover:

When the size of the turnover increases, so do trading or transaction costs. High-turnover ETFs can be more expensive to trade, and it is essential to keep an eye on them when selecting an ETF.


ETF Rebalance:

The more frequently an ETF rebalances, the more costly it is to trade. This is because the fund managers will need to buy or sell the underlying assets, and these increase the transaction cost. So, before you invest in an ETF, spend some time checking the ETF’s historical rebalance frequency.


Should we know the exact total cost of ETF ownership? | The Globetrotting Investor | Value Investing
ETF Rebalance

Premium/ Discount to NAV:

Premium/ discount to NAV is a measure of how closely the market price of an ETF is aligned with its NAV. The NAV of an ETF represents the value of the underlying assets in the fund, calculated by dividing the total value of the assets by the number of shares outstanding. The market price of an ETF, on the other hand, is the price at which the ETF is trading in the open market.


If the market price of an ETF is higher than its NAV, it is said to be trading at a premium to NAV. Conversely, if the market price of an ETF is lower than its NAV, it is said to be trading at a discount to NAV.


A premium or discount to NAV can indicate issues with the ETF's creation/ redemption process. If the ETF is trading at a premium, it could mean that demand for the ETF is higher than the supply of shares, which makes it difficult to create new shares. If the ETF is trading at a discount, it could mean that supply of shares is higher than demand, which makes it difficult to redeem shares. It is ideal for an ETF to trade close to its NAV, as it indicates that the ETF's creation/ redemption process is functioning smoothly and that the market price of the ETF reflects the value of its underlying assets.


The premium/ discount to NAV affects the cost of ETF ownership, as it influences the price at which investors buy or sell shares. If the ETF is trading at a premium, investors will have to pay a higher price to buy shares, which will increase the total cost of ETF ownership.


Opportunity Cost:

Some studies even include opportunity cost as part of the total cost of ETF ownership. Opportunity cost is the foregone return of choosing one investment over an ETF.



Now that you have understood the different types of costs associated with ETF ownership, then the next question is...


Should we know the exact total cost of ETF ownership?


My answer to you is if you can calculate the above-mentioned costs to a certain level of accuracy then yes. Also, if you are investing a lot of money into ETFs or you have a professional investing for you, then you should know the total cost of ETF ownership.


If not, it is not necessary to know the exact total cost of ETF ownership.

The concept of the total cost of ETF ownership is more theoretical than practical. It is not a must-know number. It is also very difficult to calculate things like opportunity cost. With that being said, however, there are three costs that you need to know as ETF investors. They are expense ratio, taxes, and tracking error. These costs can add up over time, and it is important to understand what they are and how they can affect your investment returns.

bottom of page