The Total Cost of Investing in Exchange Traded Funds (ETFs) and Mutual Funds

Total Cost of Mutual Funds and ETFs.JPG

When comparing different ETFs and mutual funds most investors only look at the expense ratio.  While this is a good starting point there are other factors in play that should be considered as well.  Bid/Ask spread, transaction costs (commissions), premiums/discounts and taxes should all be factored into your analysis.  Costs add up over time and are one of the most easily controlled parts of your investment decision so an understanding of all of the costs is an important part of creating an efficient portfolio.

For an example we will walk through the total cost of investing in the Vanguard Emerging Markets ETF with the ticker symbol VWO.  We will invest a hypothetical $10,000.

First let’s start with the expense ratio as this is the most common and incorporates much of the overall cost of the fund.

VWO has an annual expense ratio of 0.18% as of 8/27/2013.  The annual expense ratio includes 12b-1 fees, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund.  This is easy to find on most financial websites but for the most up-to-date numbers check the prospectus.  Both mutual funds and ETFs have this expense which makes for a quick comparison and the best starting point for our analysis.  This fee is paid by the owner of the fund annually.

Cost of VWO = $10,000 x 0.18% = $18.00/Annually

Next up is transaction costs or commissions.  This is the cost of actually buying and selling the fund.  This is can vary depending on your broker.  Scottrade for example charges $7 for each trade; Charles Schwab charges $8.95 for each trade.  These transaction costs are included on both ETFs and mutual funds.  Included in this category can also be loads.  Loads are additional sales charges unique to mutual funds, can be over 5% per transaction (are completely unnecessary) and should be included in your calculation for total cost if analyzing a mutual fund.  Since we are long-term investors, for our analysis we will assume one purchase per year.  This would be the initial purchase and then an additional buy or sell annually for rebalancing.  I use Scottrade as a custodian so I will use their commission rates for this analysis.

Cost of VWO = $7.00/Annually

Onto one of the harder to find numbers and often overlooked costs which is the bid/ask spread.  All stocks and ETFs have both a bid and an ask.  The "ask" is the price at which an ETF can be purchased, and the "bid" is the price at which the same ETF can be sold.  The difference between the two is the bid/ask spread.  For example let’s say VWO is trading with a bid/ask of $42.15/$42.20. The spread is $0.05. If you purchase it at the market you will pay 42.20.  Once you own it, assuming the market hasn’t moved yet, and you want to sell it you would only receive 42.15.  Bid/Ask spreads can be vary greatly and are largely dependent on the volume of shares being traded.  The average spread on VWO is 0.02% based on Vanguard’s Institutional Investor Website.  This is almost inconsequential but as I mentioned can easily get as high as a couple percentage points.  Mutual funds do not have bid/ask spreads since they are priced only once per day and everyone pays the same price.

Cost of VWO = $10,000 x 0.02% = $2.00

Another often misunderstood cost is the premium or discount to a fund’s Net Asset Value (NAV).  A fund is trading at a “premium” if you pay more for the ETF than its holdings are actually worth. Similarly, a fund is trading at a “discount” if you pay less for the fund than the value of its holdings. For example, let’s say VWO is trading at $40 per share.  If you were to add up all of the stocks held by VWO they would be worth 39.90.  In this case VWO would be trading at a $0.10 premium or 0.25%.  Most ETFs have small premiums and discounts but larger ones can show up in less liquid markets such as with bonds and commodities.  It is not necessarily the premium or discount that is a concern but the change in the premium or discount from when it is purchased.  If an ETF is purchased with a 1% premium, it will not affect the investors return unless that premium decreases by the time they sell.  This could also end up being a benefit if the premium increases by the time they sell.  Open ended mutual funds do not trade at premiums or discounts

Cost of VWO = 0.04% Discount (11/04/2013) – for our analysis we will exclude this because we do not want to assume a change during the holding period.

ETFs and mutual funds will sometimes distribute capital gains which creates taxable income for the investors.  Morningstar created a tax cost ratio which measures how much of a fund’s return is reduced by the taxes investors pay on distributions.  From the Morningstar website:

“Like an expense ratio, the tax cost ratio is a measure of how one factor can negatively impact performance. Also like an expense ratio, it is usually concentrated in the range of 0-5%. 0% indicates that the fund had no taxable distributions and 5% indicates that the fund was less tax efficient."

"For example, if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis.”

Cost of VWO = 0.86% 5-Year Tax Cost Ratio or $86/year

If we account for all of the above costs our $10,000 investment costs about $113/year or 1.13%.  This 1.13% total cost expense ratio is significantly different from the 0.18% expense ratio.  This is not a commentary on VWO or its viability as an investment instead I am using it to show that there are many other costs associated with ETFs and mutual funds.  When comparing various investments expenses are an important part of the analysis and you may want to consider some of these other costs.  Keep in mind the variability of some of these inputs.  Trading commission depend on the broker you use not necessarily the fund you choose.  Also, these commissions can become a large part of the overall expense if you trade frequently.  Your analysis will change if you assume ten trades per year versus one like I did above.  In the case of VWO the tax cost ratio was a large part of the overall expense.  We used the 5-year tax cost ratio for our calculation but this can fluctuate year-over year depending on the capital gain distributions. For example, VWO has a one year tax cost ratio is 1.06% and a three year ratio of 0.76%.  Also, uses the highest federal tax rate when dealing with short-term capital gains and income and the 15% rate for long-term capital gains.  You own tax situation may differ.