Although exchange-traded funds, or ETFs, can offer you greater diversification, lower risk and the ability to track a particular index or market sector, one expert said it’s important to look at an ETF’s expense ratio, or the cost to administer the ETF, when determining the cost of the investment.
“Do the potential returns of the ETF have the ability to cover the expense ratio and provide enough of a return for the amount of risk you are taking? The key here is to compare the investment to its relative index benchmark to see how well the ETF is delivering against its level of risk,” Leanna Devinney, vice president and branch leader at Fidelity Investments, said.
While ETFs can offer investors an inexpensive way to participate in a wide variety of investments including bonds, stocks, real estate and commodities of all shapes and sizes, Eric Wiegand, a senior portfolio manager at U.S. Bank, agreed that it’s important to understand the costs associated with them.
“Costs can appear in the form of the expense ratio, commissions and bid-ask spread,” he said. “Expense ratios represent the cost associated with managing the fund.”
Wiegand explained since many ETFs are passive vehicles or are intended to copy a particular benchmark (like the Standard & Poor’s 500 domestic stock index), they can be low-cost. However, some specialty ETFs may be actively managed (intended to exceed the return of a stated benchmark) or may be more focused on less-liquid areas that may carry meaningfully higher expenses, he said.
It’s also worth knowing that since ETFs are traded on an exchange like typical stocks, they may incur a brokerage commission.
“Some large brokerage firms will offer commission-free trading for a range of ETFs available on their platform,” adds Wiegand.
And, as with other investments, Wiegand says the spread represents what an investor will likely sell a security at (bid) and likely buy at (ask).
“If the ETF is in a very liquid asset category, this spread may be very narrow. However, less liquid specialty areas may see a larger difference between the bid and ask,” he continues.
Finally, beyond the costs associated with any investment, Wiegand states it is imperative that investors understand the nature of the underlying investment and risks associated with an investment.
Additionally, ETFs aren’t often associated with large fees, but because they are traded like stocks, investors typically pay a commission to buy and sell them. Since ETFs are traded directly on an exchange, they may be subject to brokerage commissions, which can vary depending on the firm, but generally do not exceed $20.
Read More: Understanding fees when you buy ETFs