Most brokers now offer investors a select group of exchange traded funds (ETFs) that can be traded without any trading fees. All else being equal, free commissions are a good thing, but there are other costs involved in buying and selling ETFs besides trading costs.
Some of the ETFs that are available without commissions don’t have adequate liquidity. ETrade’s commission-free list for example, includes some ETFs like WisdomTree Global Equity Income (DEW) that we’ve opted to remove from NoLoad FundX because they lacked liquidity. As we showed in our July 2011 post, How to Spot Thinly Traded ETFs, DEW had gaps in its trading history and its bid/ask spread was wide.
The bid/ask spread is the difference in the lowest price a seller is willing to accept and the highest price a buyer is willing to pay as of the last trade. When the spread is wide, you could end up paying more for the ETF than it is actually worth – and this can easily add up to more than a broker’s transaction fee.
Unlike open-end mutual funds which are bought and sold at Net Asset Value (NAV), ETFs are traded throughout the day at whatever price clears the market, and at times, an ETF’s price may deviate from its NAV. When an ETF’s price is more than its NAV, the ETF is trading at a premium. When an ETF’s price is less than its NAV, the ETF is said to be trading at a discount. If you buy an ETF at a premium, you’ll be paying more than you need to and putting yourself at an immediate disadvantage. Likewise, if you sell an ETF at a significant discount to NAV, you’ll essentially shortchange yourself on some of the gains.
Another issue with broker’s commission-free ETFs is that these ETFs are not always the best performing ETFs. At most brokers, the trading commissions for ETF trades are usually relatively small – usually around $7-15 for market orders — but the difference in return between two ETFs can be huge.
Consider Fidelity’s list of ETFs available without trading costs. Although Fidelity’s list primarily includes ETFs that track broad market indexes, like the large-cap S&P 500 and the small-cap Russell 2000, there’s just one sector ETF: iShares Dow Jones US Real Estate (IYR). IYR isn’t a bad option. It gained 5.5% in 2011, which was less than Fidelity Real Estate (FRESX), up 8.3%, but more than CGM Realty (CGMRX), up 1.0%. But other sector ETFs even performed better. PowerShares Pharma (PJP) gained 20.0% for the year, iShares Dow Jones Utilities (IDU) was up 18.7%, and SPDR Consumer Staples (XLP) gained 14.1%.
While it’s nice to avoid additional fees when possible, it’s worth knowing what you may be giving up if you select only commission-free ETFs.