What’s not to like about exchange traded funds (ETFs)? These nifty investments trade like stocks, are based on the most popular market indexes around, and sport rock-bottom fees. They can be bought and sold throughout the trading day and are more liquid and more tax efficient than their popular ancestors, the open-end mutual fund.
But not everyone is convinced that ETFs are the way to go. Some cite the commissions that must be paid to buy and sell these instruments. Others are concerned with the bid-ask spread, which adds another layer of trading costs.
Certainly, not all ETFs are created equal. The more esoteric the benchmark, the more problematic it is to trade them. Take the iShares MCSI Malaysia Fund (EWM), which tracks the mostly small-cap MSCI Malaysian stock index. With its 0.59% expense ratio and 0.30% bid-ask spread, this fund will cost 0.89% to own in the first year. After adding commissions (assuming a flat $15 ticket charge on $10,000), the total cost is 1.04%.
But then there’s the premium/discount issue to worry about. Even though ETF shares are traded using specific mechanisms to avoid such spreads, EWM trades at a 0.43% premium to the stocks it actually owns. As a result, the first-year breakeven on a purchase of EWM is 1.47%.
Although that may sound pricey, most open-end funds that specialize in this region are even more expensive. In fact, the EWM would place in the bottom decile of the 82 mutual funds that track the Pacific Rim in terms of total expense ratio. Moreover, since expenses such as commissions and spreads are one-time charges, a long-term investor in EWM is likely to pay less in fees over time than most mutual funds.
Of course, there aren’t that many investors looking to get exposure to Malaysia, but there are scads trying to get access to large-cap U.S. stocks. The table below compares the total expense ratio of a number of large-cap offerings. Since the bid/ask spread and the premium/discount of ETFs vary significantly throughout the trading day, the table is only a rough estimate of such costs.
The table shines several lights on the ETF- versus-mutual-fund conundrum. First off, it’s the one-time charges–the commission, bid/ask spread, and the premium/discount–that can make ETF investing a bit painful in the first year. Long-term in-vestors only have to pay these fees once, which usually makes ETFs a better choice. For dollar-cost-average investors, it’s probably better to go with traditional open-end funds.