There are significant misconceptions that exist about the total expense ratio of ETFs, including among some people considered ETF experts. The total expense for shareholders often includes the following: management fees, operating expenses, 12b-1 fees (yes, there are ETFs that charge a 12b-1 fee), commissions and bid/ask spreads. Commissions and spreads are usually listed as transactional or one-time expenses. As an example, if an ETF is bought and held for 10 years, then only the commission and technically half the spread are paid once, with the other fees charged on a continuous basis during the holding period.
A variety of other fees apply to both mutual funds and ETFs, with some more visible than others. Underlying fund fees are a prime example. If a portfolio manager chooses to buy the SPDR S&P 500 ETF (SPY) over purchasing all 500 securities within the S&P 500, then that manager's fund must list the underlying fund fees of SPY. On the other hand, a manager who buys individually all 500 securities of the index also incurs significant charges, but is not required to disclose those costs in the expense table—however, the costs are there and can impact the performance (or NAV calculation) of the fund. It's an unfortunate inconsistency in the regulatory reporting requirements.
When looking at how the industry classifies and calculates total expenses associated with buying and selling ETFs, it's critical to break down those expenses into two categories: negotiable and non-negotiable.
Non-negotiable expenses include the management fee, operating expenses and, if the ETF has one, a 12b-1 fee. Likely the only items that change over time are the management fee and the operating expenses. The management fee can change if the ETF provides for break points as it grows more assets under management. An ETF's growth should also reduce operational expenses, as a component of those expenses are flat fees that gradually become a smaller percentage of total assets over time as a fund increases in size.
It's important to focus on the negotiable fees, beginning with the commission where, at a minimum, investors have many choices to place trades as all brokers charge different rates. The ability to select where to buy and sell ETFs allows for the ability to lower commissions. In fact, many brokerage firms offer free trading promotions for new accounts. Depending on the size and frequency of trading, an advisor can call a broker and negotiate a preferred rate or periodic rebates on commission (it never hurts to ask).
The most significant negotiable fee is the bid/ask spread. If an ETF trades at a few pennies or less per share then there is probably not much to negotiate. However, some ETFs don't trade as often or with as many market makers actively making a market. Thankfully, an increasing amount of education has emerged to help investors know that trading volume does not represent the liquidity of an ETF. When well-known ETF analytic firms create liquidity scores by simply accepting listed spreads as actual trading prices, it significantly misrepresents the actual cost to trade an ETF. With the use of limit orders, market makers can view and execute a bona fide trade within a reasonable value of the ETF.
For an advisor, it's important to recognize that ETF analytics or grading services that use posted spreads do not fully realize that the actual cost of the transaction can be—and often is—significantly better. This is the value add that advisors bring as actual practitioners of ETF trading and execution, primarily because they understand what some ETF analysts do not.