The commission-free ETF craze is a growing trend among brokers fighting for your investment dollars. Free is a big selling point.
With ETFs already a popular alternative to mutual funds, taking advantage of an opportunity to cut commissions is persuasive. Your current online broker may already offer commission-free ETFs as an investment choice. But is it the best option for you?
Commissions Are Relative
A $5 to $10 trading fee may not seem like much but brokerage commissions are just a cost to your portfolio’s returns. Every dollar you spend must be made back just to break even. The cost is relative when you consider the amount you’re investing. But as the table below shows, the return you need to break even can be very high.
|Invested Amount||$5 Commission||$10 Commission|
For every investment, a commission is paid when you buy a fund and again when you sell it. The table above shows that lower investments need a higher return to break even. That falls as you invest with larger amounts of money.
For anyone investing $100 each month, those trading fees can really set you back. Trading in and out of funds too often, makes it worse. Commission-free ETFs offer a compelling option, especially when putting your money to work immediately.
As your money grows, the break even return is minimal. You can easily make up that tenth of a percent difference in break even return by investing in an ETF with a lower expense ratio.
Not All ETFs Are Equal
Commission free is a big selling point, but there’s a catch. Fund companies don’t manage all that money for free. The cost to manage a fund, the expense ratio, is passed on to shareholders each year. Put another way, it’s the cost you pay the fund company each year for investing in the ETF. This happens whether the fund is up or down for the year.
Since costs are a drag on investment returns, all things being equal, you want the lowest expense ratio possible. Lower costs keep more of your money invested and compounding over the years.
A quick search through an ETF screener shows that of the 1,600+ listed, the expense ratios ranged from 0.04% to 2.32%. That’s a big difference. On a $10,000 investment, the cost to you ranges from $4 to $232 annually.
This is something I’ve discussed before with index funds and it pertains to any fund – the costs of similar funds are not the same.
Before you invest, find the category of ETF you want and compare the expense ratios of each one. If, for example, you want to invest in an S&P 500 ETF, look through your choices. The lowest cost ETF is almost always the best choice.
With commission-free ETFs in the mix, as shown above, it depends on how much you invest. Check with your broker to see what’s available. You might find a similar fund with a competitive expense ratio that is offered commission free.
Read The Fine Print
Many of the commission-free offers come with requirements you must meet. If you don’t, you get charged the commission after the fact.
From what I’ve seen among different online brokers, these requirements range from meeting a minimum balance limit to holding the ETF for a required time period.
Right now, TD Ameritrade offers the widest selection of commission-free ETFs, but with a 30 day holding period (seems to be the norm across most brokers). Other brokers are getting more competitive with their offers. Here’s a list of the best brokers for ETFs.
Her’s one final note. If you’re just starting out, commission-free ETFs offer a great way to invest with small amounts of money, but only when the expense ratio is competitive. As your money grows, paying a commission may save you more over the long run.