ETF cost structures

Trading ETFs is similar to trading stocks.

But, if you plan to buy ETFs, know there are additional costs on top of management fees. First, like a stock you’ll pay a commission to transact the purchase on an exchange.

Then, there’s the spread between what traders call the bid (the price at which an ETF can be bought) and the ask (the price at which that same ETF can be sold).

Unlike management fees on a mutual fund, which are paid for the duration of the holding period, transaction costs are incurred every time you buy or sell an ETF. So, the more frequently you trade, the higher your fees. Again, these transaction costs are in addition to any management fees.

To save trading costs, Atul Tiwari, managing director of Vanguard Investments Canada, notes people making small purchases may be better off with mutual funds. But, “when you get into anything that’s reasonable size, then the cost of holding an ETF over a period of time will be to your advantage,” he says.

Selecting ETFs

You have a choice of more than 280 Canadian-issued ETFs, and more than 1,000 U.S. offerings.

When analyzing ETFs to place in client portfolios, Tim Morton, a financial advisor at CIBC who specializes in ETFs, looks at several factors:

• Consistency of the return. Morton’s team examines an ETF’s returns within several time frames – including quarterly and semi-annually – over a 12-month period. This lets him determine the smoothness of an ETF’s return. They look for ETFs with consistent, gradual price rises. Of course, such criteria effectively exclude ETFs with volatile underlying holdings, or those built from equities for which there is less market demand.“That tends to refine [our choices] down to about 40 to 50 ETFs,” says Morton. With this narrower ETF universe to choose from, his team then looks for ETFs in economic sectors that are less represented in a client’s overall portfolio. This improves diversity.
• Spread between the bid and ask prices – Morton says he generally transacts on ETFs with a one-to-two-cent spread between the bid and ask price on ETFs that have been pre-screened for consistency of returns. A higher bid/ask spread indicates market participants are having difficulty creating new ETF units.
• Management Expense Ratio (MER). All else being equal, Morton makes sure his selection of passive ETFs sport lower MERs – the costs associated with running the funds. This allows him more room to pay for pricier actively managed ETFs in the portion of the portfolio where he’s looking to capture upside. “We like some of the active ones,” says Morton. “They’re in our portfolio today and they’re more expensive.”
• Additional ETF features (such as currency hedging) – Morton’s team has recently stayed away from ETFs with tax-efficient features, such as using derivatives to convert income into capital gains, because the latest budget rules phase them out. “Probably the biggest thing that we’re looking at if it’s not a Canadian ETF is – can we buy a currency hedge?” he says. Canadian short interest rates are now higher than U.S. short interest rates so it pays to hedge, he says.
• Short-selling options – Some ETFs can be lent to short-sellers, which gains a rebate from the loan proceeds. “That’s “been a very efficient way of cutting our effective MER,” says Morton.

Dean Allen of Vanguard Investments Canada applies three rules to ETF trading:

• Avoid trading at the market open and close. He tries not to place trades within 15 minutes of the market open or close, because those periods are when prices tend to be volatile. That can drive up spreads and transaction costs.
• Always use a limit order, which lets you buy or sell a stock at a set price or better, and protects the price at which you execute a trade. A market order, by contrast, doesn’t let you control execution price.
• Reason out an ETF’s liquidity (the market appetite to buy that ETF) by looking at its underlying stocks or bonds. The less risky the holdings, the more liquid the ETF.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.