Your ETF Might Not Be As Cheap As You Think

by: The Financial Lexicon

The costs of owning a fund are something investors should be keenly aware of when building their portfolios. While many investors have been trained to look at expense ratios, there are other very important cost considerations to keep in mind. When examining ETFs with expense ratios that are virtually identical, such as the SPDR S&P 500 (NYSEARCA:SPY) and the iShares S&P 500 Index Fund (NYSEARCA:IVV), other deciding factors will come into play when choosing which fund to purchase. Depending on the type of investor you are, the broker you use, and the underlying investments of the ETF you intend to purchase, you may discover that a particular ETF is not as cheap as it initially appears.

In "2 Helpful Tips For Comparing ETFs," I outlined two such costs that can have a dramatic effect on whether one ETF ends up cheaper than another. For investors who own funds that receive foreign dividends, the percentage of non-qualified dividend income (QDI) is one hidden cost investors might not even realize exists until tax time comes around. Furthermore, in today's world of brokers offering free trades on any number of ETFs, investors who dollar-cost average into positions might discover that a fund with higher advertised expenses becomes the cheaper fund after commissions are brought into the equation. For much more detail on QDI and commissions as they relate to ETF costs, please read the aforementioned article, linked above.

As previously mentioned, depending on the type of investor you are, you may be subject to different costs associated with owning an ETF. Sometimes those costs are less obvious. Another example of an often overlooked cost is one related to options trading. If you are an investor who likes to trade options, there is certainly a cost of choosing one fund over another. Before purchasing an ETF that you think is cheaper from a cost perspective, option investors should consider the following:

1. Does the ETF in which you want to invest have an option chain? Be sure to check this before making your purchase. This may be an obvious consideration, but it is still worth mentioning.

Gold investors deciding between the SPDR Gold Shares (NYSEARCA:GLD) and the Sprott Physical Gold Trust (NYSEARCA:PHYS), who also are interested in buying protective puts or selling covered calls on their positions, might choose GLD over PHYS because GLD has an option chain and PHYS does not. This might occur despite certain advantages from a tax and ETF structure perspective that would lead many investors to favor PHYS. After all, if, for example, you plan to sell covered calls several times a year over a period of many years, then an additional cost of owning PHYS is that you would lose the opportunity to collect premiums from option sales.

2. The next step is to consider the impact of specific characteristics associated with an ETF's option chain. This is perhaps the most important thing an ETF investor who also trades options should consider when examining fund costs. You may be tempted to go with the ETF that has a much lower expense ratio, but if that ETF's option chain has extremely wide bid-ask spreads, then, over time, the cost of getting a fill on that option chain might outweigh any benefits from the lower expense ratio.

Also, the depth of the options market for a particular ETF may be a concern for some investors, especially institutional ones. If you cannot get filled at reasonable prices in the size you want to get filled, any cost benefits from the expense ratio may be outweighed by the lack of depth in the options.

Finally, the option chain offering more selection in terms of expiration dates will afford investors far more opportunities for collecting premiums or hedging investments. If one ETF you are considering has a higher expense ratio than another, but it offers weekly, monthly, and quarterly option expiration dates, that ETF may end up being the cheaper fund for you over a longer period of time.

Two ETFs tracking the same index are the Vanguard MSCI EAFE ETF (NYSEARCA:VEA) and the iShares MSCI EAFE Index Fund (NYSEARCA:EFA). Vanguard's fund sports an expense ratio of 0.12%, far less than the iShares fund's expense ratio of 0.34%. But an investor wanting to sell covered calls against his or her position will find far more choice in terms of option expiration dates with the iShares fund. An investor will also find much narrower bid-ask spreads on EFA's option chain, especially for at-the-money or slightly-in and slightly-out-of-the-money options.

When examining which of two or more funds is cheaper from a cost perspective, investors should take into consideration much more than just the advertised expenses of the fund. While it is tempting to only look at the expense ratio as an easy way of differentiating the cost of owning various funds, it does not tell the entire story. Non-qualified dividend income, commissions, and option chain characteristics are three examples of ETF costs that investors should not overlook when searching for the cheapest fund.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long gold.