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Exchange-traded funds (ETFs) are low-cost, beginner-friendly investments that can move clients closer to their long-term goals. However, many investors may assume the expense ratio is the full cost of ETF ownership, leaving financial advisors to fill in the rest of the picture regarding other expenses like bid-ask spreads, tax implications, and other fees.
To ensure that your clients make sound decisions about what investments best align with their goals, you’ll need to educate them. Using analogies, like car buying, to explain ETF costs and fees can help make this complex financial topic consumable for all your clients.
Key Takeaways
- The expense ratio is the cost investors are typically most familiar with, but it’s only a portion of the total cost of owning an ETF.
- Bid-ask spreads may cause frequent traders to lose money, particularly to wider spreads.
- Even tax-efficient ETFs may still trigger taxable events like capital gains distributions and dividend payments, depending on the account type and fund activity.
- Investors must understand how applicable custody fees, transaction fees, and wrap advisory fees can drive up the cost of ETF ownership.
- Use analogies and dollar amounts when discussing fees to help clients understand.
- A slightly higher cost ETF may be worth it for a client’s specific investment strategy.
Expense Ratios: The Most Familiar Fee
Many investors assume an ETF’s expense ratio is the full cost of ownership. Its clear expression as a percentage of assets under management (AUM) makes it easy to understand and compare. Because it’s so visible and simple to calculate, investors often stop there—missing that the expense ratio covers only part of the total cost.
Expense ratios include management fees and administrative costs. They do not include trading costs, bid-ask spreads, taxes, or platform expenses.
Tip
To show clients the real-world cost of ownership is more than just what is printed on the prospectus, explain what the expense ratio includes and what it doesn’t.
Trading Costs and Bid-Ask Spreads
A commonly overlooked cost of ownership in ETFs is the bid-ask spread, or the difference between the lowest price the seller is willing to accept (ask) and the highest price the buyer is willing to pay (bid). In ETFs with high liquidity and trading volume, the spread is narrower compared to situations with less supply and demand, where the bid-ask spread widens and the client’s trading cost increases. The more frequently the client trades, especially in low-volume ETFs, the more this spread costs the client.
You can use a car-buying analogy to explain the bid-ask spread to your clients. Imagine shopping for a car, and the dealer is asking $15,000, but you only want to pay $14,000 (bid). The dealer may choose to accept your offer if there are no other buyers. However, if multiple potential buyers are interested, the dealer will likely sell to the person who comes closest to their asking price, potentially increasing the amount you’re willing to pay. Conversely, if you turn around and sell the car the next day, you may only get $14,800 for a car you paid $15,000 for.
Tax Efficiency Isn’t Automatic
ETFs are generally tax-efficient, certainly more so than other “baskets of securities” like mutual funds, due in part to in-kind redemptions. Still, they’re not tax-free or exempt from capital gains tax on taxable events.
Clients should understand events that trigger taxes, like selling for profit, dividend income, and special distributions. Anytime clients actively sell shares for a profit, they’ll likely incur a capital gains tax. Additionally, clients may receive dividend income, taxed annually, from their ETFs.
You should help match ETFs with the right account types for your clients. Tax-efficient ETFs may help clients reach their goals in their taxable accounts, but tax-inefficient ETFs may be better suited for IRAs or 401(k)s.
Other Fees and Platform Considerations
Even the cheapest ETFs may have other fees that could drive up the total cost of ownership. To ensure your clients understand the full picture, you must address the additional fees that clients may encounter down the road. Here are some common fees to disclose to clients:
Custody Fees
Custodians (like Fidelity or Schwab) charge a custody fee to store, track, and keep investments safe. These are particularly common in retirement accounts. You can explain these to your clients by comparing custody fees to the cost of keeping their new car in a secure garage that protects it from theft and weather damage.
Transaction Fees
Each time your client places a trade, it may incur transaction fees. While your brokerage may offer “commission-free trading” for ETFs and stocks, trading platforms may charge a small fee. When considering these fees in a car-buying analogy, explain to clients that these fees are similar to a dealership charging a title transfer fee. Even if your client goes into the transaction knowing exactly what they want, they may have to pay transaction fees to execute it.
Advisory Wrap Fees
These fees typically range from 1-3% per year of portfolio value. These fees remunerate advisors and brokerage firms for investment advice, account management, commissions, and trading fees, all rolled into one. Advisory wrap fees would be like paying a yearly fee that covers a car’s garage storage, maintenance costs, and a driving instructor.
Helping Clients Evaluate Total Cost
ETFs are a solid choice for many investors. They are an excellent choice for new investors due to their built-in diversification, accessibility, support of long-term goals, and low cost. However, investors new to ETFs must understand the actual costs of ETFs to know if they’re a suitable choice for their goals. To help clients better understand, consider using a series of questions to illustrate to the client the total cost of their ETF ownership:
- Expense ratio: How much does the fund charge annually, as listed on the prospectus or fund fact sheet?
- Bid-ask spread: How wide is the spread? How often does the client plan to trade?
- Taxes: Does this ETF give distributions? What kind? Will the ETF be in a taxable or tax-advantaged account like an IRA?
- Other Fees: Does the custodian charge a fee? Is there a transaction fee through the platform? Does my brokerage firm charge an advisory wrap fee?
Tip
To explain these fees to your clients, it’s beneficial to use dollar amounts instead of percentages. For example, say, “XYZ ETF could cost you $10 per year” instead of saying “0.3% annually.”
After disclosing the costs, ensure your clients know that cost is not the only factor. A slightly higher overall cost may be worth it if the ETF offers diversification, accessibility, and best supports the investor’s strategy.
What’s the Difference Between an ETF’s Expense Ratio and Its Total Cost?
The expense ratio is just one portion of the total cost of owning an ETF, but it’s the most recognizable cost indicator among many investors. The total cost of an ETF includes the expense ratio, spreads, trading fees, taxes, and other platform-based expenses such as custodial fees, transaction fees, and advisory wrap fees.
How Can I Explain Bid-Ask Spreads to Clients in Simple Terms?
Car-buying analogies can help clients understand big-ask prices. The asking price is what the seller lists the car for. The bid price is what the buyer is willing to pay for the vehicle. If the buyer offers less than the seller’s ask price, then the difference between the two is the bid-ask spread. When markets are thin, the bid-ask spread widens because there aren’t enough sellers for buyers and vice versa.
Are Some ETFs More Tax-Efficient Than Others?
The short answer is yes. The long answer is that broad-based index ETFs are usually more tax-efficient than actively managed or niche ETFs; however, investors should also consider dividends, capital gains distributions, fund structure, asset class, and the fund’s redemption process when analyzing tax efficiency. Advisors can recommend putting less tax-efficient ETFs into tax-advantaged accounts like 401(k)s and IRAs to offset some of the tax liability.
Should Clients Avoid ETFs With Higher Expense Ratios Altogether?
Higher expense ETFs may not be suitable for everyone. Still, the higher cost of the ETF may be justified for investors needing the unique exposure, diversification, or strategic benefits that the ETF offers.
How Do I Help Clients Compare Similar ETFs With Different Fee Structures?
The easiest and most user-friendly way to compare ETFs with different fee structures is to create a side-by-side comparison using dollars, not percentages, to illustrate the actual cost to the investor.
The Bottom Line
ETFs have many features that make them a solid investment choice for many investors, but before recommending them for a client portfolio, you should ensure that they have a firm grasp on the total cost of ownership.
Many clients will recognize the expense ratio, leaving you to explain and illustrate the other associated costs, such as bid-ask spreads, tax liabilities, and platform-specific fees. By ensuring your client knows everything they need to know about ETF cost, you’ve empowered them to make confident decisions that support their goals at a price they can afford, as well as building trust that you can’t buy.
