ETFs – exchange traded funds – have long been sold as the cheap alternative to actively managed funds. The argument has always been that a passive, listed fund is going to beat unit trusts and mutual funds on price, and frequently they do.
But investors need to be a little more savvy when it comes to screening the ETF funds universe. They need to concentrate on the TER – the total expense ratio – that is used as a measure of the cost of owning an ETF. While ETFs can be traded like shares, unlike listed companies, they charge a fee to investors who hold them.
The cost of investing in ETFs
The TER is a relatively good measure of the expense of an ETF. But on top of that, pay attention to the bid-offer spread. This is the difference between the buying and selling price. For the most liquid ETFs this can be very low indeed and should be around a a few basis points (hundredth of a percentage). In the less liquid ETFs however, this can quickly jump to as high as 1%.
The bid-offer spread is frequently a good indicator of the relative liquidity of the market your ETF is itself investing in. ETFs that ply their trade in emerging markets stocks or small caps will have a bigger bid-offer spread than, say, one that is focused on S&P 500 shares. Bid-offer spread can also be affected by structural issues in the market, e.g. with the authorised participants (market makers) for that ETF.
The authorised participant is the bank usually tasked with exchanging ETF units for underlying securities. If an ETF has a lot of them, then the arbitrage mechanisms they use will work efficiently. But if there are only one or two participants, that mechanism will not work as well. This can lead to wider spreads, which are an additional cost that you, the investor, have to shoulder.
On ETF liquidity and tax issues
ETFs are meant to be very liquid instruments to trade however, and unless you are moving very significant sums in and out of these funds, other liquidity issues should not be a consideration for private investors in the ETF market. ETFs are open-ended, unlike investment trusts, allowing the market makers to create new shares for investors as demand occurs. They can also be sold short and traded throughout the day.
Most of the larger ETFs on the market including the money market funds will have very small spreads. Even a spread of 1% is not going to be a big issue unless you are a very active trader of ETFs.
One other cost consideration will be tax. In Europe the vast bulk of ETFs are domiciled in Ireland or Luxembourg; if you live outside those countries, be aware that distributions from these funds can be treated as foreign dividends. Much will depend on which jurisdiction you dwell in – there are still some with zero tax on overseas dividends, but sadly the UK is not one of them. Most European ETFs ARE eligible for tax-free investment structures like UK ISAs. In the UK ETFs are also no longer subject to stamp duty as they are classified as secondary market trading.
Note however that holdings in ETFs that invest in bonds are liable to CGT. ETFs still remain a practical and cost-effective way to access corporate and government bond markets at the moment.
