Can You Really Afford A Commission-Free ETF?

Sure, we all like things for free, especially when it comes to investing. But is FREE always the best way to go when it comes to the purchase of ETFs? The WSJ (subscription required) had some thoughts on the matter in “The Limits of Free:”

“Free” is a hard word to resist.

That’s what five big investment houses were counting on when they rolled out exchange-traded funds without trading commissions.

But whether investors should take the no-commission route is by no means a no-brainer.

Commissions have long been a shortcoming of ETFs. Long-term investors tend to like ETFs for the low expense fees, tax efficiency and indexed approach they offer. But for investors who contribute small amounts to their portfolios on a regular basis—or even only now and then—commissions on ETFs can add up.

San Francisco-based Charles Schwab Corp. made the first move, introducing a line-up of commission-free ETFs back in November 2009. Fidelity Investments, Vanguard Group, TD Ameritrade Inc. and St. Louis-based Scottrade Inc. have all followed suit.

But investors shouldn’t assume that an absence of commissions puts all of the products in this category on a level playing field. Indeed, each firm’s products vastly differ. There are big gaps in the kinds of sectors and themes covered, additional fees can be charged, and expense ratios vary, too.

Ameritrade offers the most choices, with 101 commission-free ETFs, all of which are managed by other companies, including BlackRock Inc.’s iShares unit, Invesco Ltd.’s Invesco PowerShares and Vanguard. The funds cover such core asset areas as fixed-income investing and domestic and international equities. Commodities and single-country ETFs are also included. Ameritrade, based in Omaha, Neb., receives no special compensation or management fees from any of the ETF providers, a spokeswoman says.

Vanguard, by comparison, has 64 commission-free ETFs, Fidelity 31, Scottrade 15 and Schwab 13. Vanguard, based in Valley Forge, Pa., and Schwab offer only their own ETFs without commissions.

The no-commission ETFs offered by Vanguard, Fidelity, Scotttrade and Schwab don’t include commodity-based or single-country funds.

“Psychologically, it’s pretty powerful” to take away the commission, says Paul Justice, an ETF strategist at investment researcher Morningstar Inc.

Mr. Justice sees the value for investors who make small trades on a regular basis. On investments of $200 to $300, he says, even a commission of $8 adds up over time, and that can be a reason to go commission-free.

“Whenever fund companies or brokerage firms compete,” he says, “investors win when [the companies] lower fees—or, in this case, offer no fee.”

There are other considerations to take into account, though, than whether an ETF comes with or without a trading commission.

In general, says Rick Ferri, founder of Portfolio Solutions LLC, don’t invest in a fund “that you really didn’t want just because you’re going to save $8 on a commission.”

Read the fine print, too: Investors can unwittingly incur fees that exceed the average commission. Ameritrade, for one, charges a $19.99 fee for trading a no-commission ETF within 30 days of buying it.

Then there are the expense ratios. Mitch Tuchman, co-founder and chief executive of marketriders.com, an ETF-focused online portfolio manager, says it can make more sense to pay the $7.95 that Fidelity charges for some ETFs than to buy an iShares ETF with no commission but higher expenses.

“There’s a cutoff point,” Mr. Tuchman says. “If you’re saving on commissions and paying five times more in fees, it doesn’t make much sense.”

Many no-commission iShares ETFs have higher expense ratios than the competing no-commission funds from Ameritrade, Vanguard, Schwab and Scottrade. BlackRock declined to comment on its iShares fees.

But high expense ratios should be weighed against another consideration: the size of the fund and the liquidity of its shares—factors that have an impact on trading costs.

If an ETF is small and thinly traded, there’s more likely to be a wide spread between the price at which you can buy the ETF and the price you’d get for selling. Wide bid-asked spreads can mean getting nicked for 1% of your purchase, analysts say.

There you have it. Just because you can save $7.95 on an ETF trade, does not mean it’s in your best financial interest. The easiest way you can pay too much is by purchasing a thinly traded ETF with a high bid/ask spread.

That’s why you hear me continually harping on buying ETF’s with high volume. In my advisor practice, that means I want to see an average daily volume of at least $10 million. That, in most cases, will give you a low bid/ask spread along with no liquidity problems when the exit doors get crowded.


About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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