While generally speaking ETFs offer lower management fees than other investment solutions, it is worth exploring all of the expenses associated with investing in ETFs.
Stated Costs of Investing in ETFs
All exchange traded funds incur expenses related to the management of the fund. Perhaps the most common expression of the fees associated with an ETF is the Management Expense Ratio (MER).
Management Expense Ratio (MER): The percentage of a fund’s average net assets paid out of the fund each year to cover the day-to-day and fixed costs of managing the fund. The figure is reported in the Fund’s annual management report of fund performance. MER includes all management fees and GST/HST paid by the fund for the period, including fees paid indirectly as a result of holding other ETFs.
Management Fee: The annual fee payable by the fund to the manager of the fund (e.g. RBC Global Asset Management) for acting as trustee and manager of the fund. This fee forms the largest portion of the MER. Included in the Management Fee are the costs associated with paying the custodian and valuation agents, registrar and transfer agents, and any other service providers retained by the manager.
Operating Expenses: Other operating costs such as fees associated with complying with national regulations and the fees payable to members of the board of governors of the ETFs.
Other Costs of ETFs
In addition to the above mentioned costs, ETFs also incur several costs that may not be as easily identifiable but may be equally important. These costs are generally incurred when buying or selling an ETF and are not collected by the ETF Manager.
Since ETFs trade like stocks on an exchange they may be subject to brokerage commissions. These commissions can be significant, especially for smaller trades. For example, buying $3,000 of an ETF through a discount broker could cost $30 in commissions or 1% of the value. Furthermore, a similar commission may be charged when selling the ETF.
Of course, commission rates vary and some investors trade less frequently than others. However, commissions should always be considered when calculating the total cost of investing in an ETF.
Discounts and Premiums
It is important to remember that ETFs represent an investment comprised of a portfolio of underlying securities. Consequently, the price of any ETF is derived from the prices at which the underlying securities are trading. There can exist a difference in the quoted price of the ETF and the combined value of the underlying securities otherwise known as the net asset value or NAV of the fund. The difference between the quoted price of the ETF and the NAV is expressed as either a premium (when the market price of the ETF is above the NAV) or as a discount (when the market price of the ETF is below the NAV). Generally this premium/discount is negligible but it is important for investors to be aware, especially during market open and close or during periods of high market volatility, that they may be transacting at levels inconsistent with the underlying securities.
A fund’s bid/ask spread is the difference between what other investors are willing to pay (bid) and accept (ask) for a given transaction. For the largest, most actively traded ETFs these spreads can be quite narrow (often just pennies), but for ETFs with lower assets or trading volumes, the spread may be much wider.