The commission-free ETF craze has been a growing trend among brokers for the past few years. With ETFs already a popular alternative to mutual funds, taking advantage of an opportunity to eliminate high commission costs can be persuasive. Your current online broker may already offer commission-free ETFs as an investment choice. But are they the best option?
Commissions Are Relative
Commissions can be the bane, to any portfolio’s returns. Those commission costs have to be made back before any positive returns are realized. A $5 to $10 commission may not seem like a lot of money. But in relation to the investment return you’ll need to break even, it can be very high.
|Invested Amount||$5 Commission||$10 Commission|
Looking at the table above shows the higher the investment the lower the break even return. For every investment, a commission is paid when you buy an ETF and again when you eventually sell it. If your starting out, investing $100 each month, commissions can destroy any potential returns. Commission-free ETFs offer a compelling option, especially when putting your money to work immediately.
If your investing $10,000 at a time the return needed to cover the commissions is minimal. You could easily pay the commission and make up that break even return of 0.1% or 0.2% investing in an ETF with a lower expense ratio.
Not All ETFs Are Equal
The expense ratio is the percent of an ETF the fund company takes each year to cover expenses. Or to put it another way, it’s the amount you pay the fund company each year for investing in their ETF. The lower the expense ratio, the more money you keep to invest. Which is a good thing and should be considered when investing in any ETF or mutual fund.
Every ETF has an expense ratio. A quick ETF search at Yahoo! Finance shows that of the 1,257 ETFs listed, the expense ratios ranged from 0.06% to 1.5%. On a $10,000 investment, that’s a potential cost to you of anywhere between $6 to $150 annually. Which is a large cost difference.
This is something we’ve discussed before in Investing In Index Funds. Find the category of ETF you want to invest in first, then compare the expense ratios of the different ETFs. If, for example, you want to invest in an S&P 500 index ETF, look through your choices. If the commission-free ETF has a competitive expense ratio it may be the best choice.
Don’t Forget The Fine Print
Many of the commission-free ETFs come with a catch. If you don’t meet the requirements, you’ll get charged the commissions after the fact. Which defeats their purpose entirely. From what I’ve seen among different online brokers, these requirements can range from only being available with a specific balance limit to holding the commission-free ETF for a required time period. The only online broker we found to have no restrictions on their commission-free ETFs was Scottrade.
Just a final note. If you’re just starting out investing, commission-free ETFs offer a great opportunity to begin investing with small amounts of money. But only if the expense ratio is competitive. Once you start investing with larger amounts, paying a commission may save you more money over the long term. Keeping the overall costs in mind, when investing, leaves more in your pockets.