Are Commission-Free ETFs Really Cheaper?

January 26, 2012

costs-calculatorMost 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.

1. Liquidity 

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.

2. Bid/ask spread

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.

3. Tracking error

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.

4. Performance

Another issue with 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.

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.

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