For any investment, it’s important to consider the total cost. This is the case for exchange-traded funds (ETFs) as well. ETFs are baskets of securities that can help you achieve your investing objectives by getting you exposure to different asset classes and mixtures of investments. Plus, they can be cost effective; many index ETFs are relatively cheap, based on their expense ratios, compared with actively managed mutual funds that focus on similar areas of the market.
However, the total cost of ownership of an ETF goes beyond its expense ratio. It includes other factors such as the bid/ask spread, tracking error (how closely it tracks its benchmark index), and, of course, commissions. Factoring in the impact of commissions can be particularly relevant for active investors who trade somewhat frequently—especially if you are making relatively small trades—as well as long-term investors executing a dollar cost averaging strategy.
Trade size matters
When it comes to the impact of commission costs, trade size matters. To understand why, assume that it costs $4.95 to buy or sell an ETF. If you had $1,000 in funds to buy and sell an ETF, that equates to paying $9.90, which is roughly 1.0% of the investment toward commissions. By comparison, if you were to buy or sell an ETF using $10,000 in funds, the same $9.90 commission would account for less than 0.40% of your funds.
As the chart on commissions as a percentage of total cost shows, commissions also comprise an increasingly larger percentage of the total cost of ETF ownership at lower trade size levels. Of course, these relationships are true not only for ETFs but also for other investments—such as stocks. What is unique about the potential to manage ETF trading costs is that many brokerage firms—including Fidelity—offer commission-free ETFs available for purchase.
Suppose you are deciding between 2 ETFs—ETF A and ETF B—that offer similar exposure to a part of the market, have the same expense ratio (e.g., 0.20%), trade at roughly the same spread (e.g., 0.01%), and have the same tracking difference (e.g., 0.01%). ETF A is offered commission-free, while ETF B incurs a $4.95 commission per trade.
In this example, a $1,000 trade size would translate to commissions of $9.90, representing roughly 82% of the total cost of buying and selling an ETF (see the table below). This is calculated as $9.90 ($4.95 x 2, which is the commission for both the purchase and sale of the ETF) divided by $12.10 (the total cost of ownership).1
As the table illustrates, the commission's proportional contribution to total cost decreases with trade size. While commission costs account for 82% of the total cost for a $1,000 trade size, they are just 4.3% of total cost ($9.90/$229.90) for a trade size of $100,000.
If you are an investor making relatively small trades, or an active investor who is frequently buying and selling ETFs, these savings can really add up. Of course, costs are just one aspect of the investing decision; investors should consider their individual objectives—including an assessment of the fundamental/technical attractiveness of the investment—and risk constraints when deciding which investment to make.
Commission impact on dollar cost averaging and rebalancing
Some investors use a dollar cost averaging strategy, which involves investing a fixed dollar amount on a regular basis—regardless of current market trends. Effectively, this can result in an overall average cost per share that is lower than it would be if a constant number of shares were bought at set intervals.2
Commission-free ETFs allow investors, particularly investors making relatively small trades in terms of investable funds, to use dollar cost averaging to more effectively manage the total cost of ownership.
Commissions also play a role when it comes to ETF portfolio rebalancing. Based on the frequency of a rebalancing strategy, and the number of positions being rebalanced, commissions can add up quickly (see the rebalancing and commissions table). Commission-free ETFs allow investors with a more active strategy the opportunity to manage the costs of rebalancing or rotating into and out of different ETFs.
There are some costs that investors have less control over—like the amount a fund charges and the size of the bid-ask spread. In addition, some funds track their index more closely than others. In some cases, the difference between the fund’s return and that of its underlying index—the tracking difference—can be greater than the net expense ratio. In other cases, the tracking difference can actually be less than the net expense ratio. This is a component of the cost equation that investors do not have control over, but it can be important nonetheless.
On the other hand, considering a commission-free ETF over a commissionable ETF offering similar or equivalent exposure—and a similar or equivalent expense ratio and tracking difference —is one way investors can decrease the total cost of ownership, particularly at lower dollar trade sizes.
While the impact of commissions is just one of many factors that should be considered, commission-free ETFs may help you achieve your objectives.
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