Online brokerage platforms may have scrapped commissions, but investors should still be wary of other costs
For online brokerage platform users in the U.S., the successive announcements to eliminate trading commissions for stocks, options, and ETFs made by different firms in October might have felt like an early Christmas present. But as generous as the offer may seem, it may prove to be a lesson in false economy for ETF investors who take advantage of it thoughtlessly.
As noted recently in the Wall Street Journal, investors may be tempted to make too many trades, or more emboldened to buy or sell ETFs even if it isn’t the wisest choice. “Trading commissions offer an additional behavioral pause,” Chris Cordaro, chief investment officer of financial adviser RegentAtlantic, told the Journal. “There are numerous studies showing that the more investors trade, the worse they perform.”
Free trades also do not represent as big a concession as investors might think. While reduced or eliminated trading costs certainly contribute to higher investment returns, other issues can be more materially important to the overall cost of an ETF trade.
Market exposure is one consideration. Given the sheer size and diversity of the ETF market today, investors could expect two or three products from competing ETF issuers for most broad-based stock and bond ETFs. Expense-ratio competition has squeezed similar funds into a narrow cost range, which means the underlying holdings and allocations as determined by a fund’s benchmark and methodology matter more than ever.
“Investors have to focus on the specific exposure,” said Matthew Bartolini, head of SPDR research for State Street Global Advisors. “For example, in small-cap equity, there’s a significant difference between the S&P 600 and the Russell 3000.”
Investors should also pay heed to tracking error, which show how well a given fund’s portfolio follows its benchmark. Issues with security availability and liquidity may make tracking some indexes more difficult — those that track small-cap stocks and non-U.S. markets, for example — in which case it is best to select funds whose managers have proven capable of minimizing the gap.
Also important is an ETF’s bid/ask ratio, which is usually minimal for established ETFs with considerable assets and trading. Citing research firm XTF.com, the Journal reported that there are approximately 1,200 ETFs with an average bid/ask ratio below 0.25%. When it comes to ETFs that experience thin trading and hold less liquid securities, spreads can go above 0.5%.
“[Free trading] will likely benefit the most liquid funds,” Bartolini said.
Investors should also consider the tax consequences of short-term trading, as capital gains on positions in taxable accounts can add up unexpectedly if not kept in check. And while investors who want to react quickly to market shifts may benefit from trading ETFs, those only looking to rebalance occasionally might still benefit from low-cost mutual funds.
