Lifting the veil on ETFs – Part 4 of 4

Warning about the fees and costs of ETFs
The expense ratio is not the only cost of investing in exchange traded funds. ETF shares must be purchased through a regular stock brokerage account. There will be commissions to both buy and sell ETFs. The commissions on buying and selling ETFs are the same as for buying and selling individual stocks. An investor who does a lot of trading in and out of ETFs will see a greater impact from brokerage commissions than from the expense ratios of the funds.

Unfortunately, the costs of Canadian ETFs are not as straightforward as one might think. Most investors don’t realize that iShares, Claymore and BMO (to name a few), disclose their fees in different ways, making apples-to-apples comparisons difficult.

The first point to understand is that Claymore, BMO and others only list their ETFs’ management fee on their websites. iShares, on the other hand, lists each ETF’s management expense ratio, or MER. The two terms are not synonymous. The management fee is only part of a fund’s overall MER. It’s usually the largest part, for sure, but it’s not the whole picture.

The management fee typically covers all of the administrative costs, the manager’s compensation, index licensing fees, all fees paid to the custodian (the investment firm that holds the securities), the registrar and transfer agent (the firm responsible for keeping shareholder records). These make up the vast majority of an ETF’s expenses. However, the management expense ratio or management fee also includes some additional costs, such as GST and the fees payable to the fund’s independent review committee (IRC), a legal requirement designed to protect investors from conflicts of interest. Read the Prospectus carefully to avoid unpleasant surprises!

There is also a Transaction Expense Ratio or Trading Expense Ratio (TER) that is not quoted in the Prospectus as it is only determined in arrears. Most Prospectus’ provide an estimate of this cost – but you only learn the exact amount at the end of the year and it reduces the value of your investment. This could add up to an additional 1% or so to your costs. These expenses are primarily the costs involved with trading commissions paid by the managers of an ETF as they shuffle the portfolio to keep it in line with a target index. It is important to add the TER to the MER for a more accurate picture of the fund’s costs.

Other fund expenses may not be included in the management fee, something you may only learn if you scour the funds’ regulatory filings and Prospectus. These may not add up to much, but ETF providers trumpet their low fees as a selling point and four or five basis points is enough to make a competitive difference and cost is cost. Remember, NOTHING is free!

Visit with me again in future issues of Money Magazine and this blog as I explore many of these issues in more detail including the difference between an INDEX FUND and an ETF.

With courtesy to:

Wikipedia, The Wall Street Journal, Morgan Stanley, iShares, Claymore, BMO, The Vanguard Group and the International Monetary Fund.

Lifting the veil on ETFs – Part 2 of 4

Stock ETFs
The first and most popular ETFs track stocks. Many funds track national indexes.

Bond ETFs
Exchange-traded funds that invest in bonds are known as Bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and move into bonds (for example, government treasury bonds or those issued by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions. There are several advantages to bond ETFs such as the reasonable trading commissions, but this benefit can be negatively offset by other fees and costs.

Actively managed ETFs
Most ETFs are index funds and as such, there is no “management” involved. Some ETFs, however, do have active management as a means to hopefully out-perform the nominal bench-mark index. Actively managed ETFs are at risk from arbitrage activities by market participants who might choose to front run its trades as daily reports of the ETF’s holdings reveals its manager’s trading strategy. The actively managed ETF market has largely been seen as more favorable to bond funds, because concerns about disclosing bond holdings are less pronounced, there are fewer product choices and there is increased appetite for bond products.

Leveraged exchange-traded funds (LETFs), or simply leveraged ETFs, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs. Leveraged index ETFs are often marketed as bull or bear funds and because of the leveraging involved, returns and losses are magnified!

ETFs compared to mutual funds

Costs
The first rule to remember – NOTHING is free! Since ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. Full-service brokers typically charge a percentage commission on both the purchase and sale and may be negotiable depending on the dollar value involved. A typical flat fee schedule from an online brokerage firm $10 to $20, but it can be as low as $0 with certain discount brokers with minimum account values. Due to this commission cost, the amount invested has great impact on costs. Someone who wishes to invest $100 per month may have a significant percentage of their investment destroyed immediately, while for someone making a $200,000 investment, the commission cost may be negligible.

ETFs generally have lower expense ratios than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions these costs are eliminated. Mutual funds may charge 1% to 3%, or more. Index fund (which by the way are NOT the same as ETFs – see future edition of Money Magazine) expense ratios are generally lower, while ETFs are normally in the 0.1% to 1% range.

The cost difference is more evident when compared with mutual funds that charge a front-end or contingent back-end load as ETFs do not have any additional loads at all. Potential redemption and short-term trading fees are examples of other costs that may be associated with mutual funds that do not exist with ETFs. Traders should be very cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time.