Are Commission-Free ETFs Worth It?

Over the past year or so, the four leading trading houses have offered a suite of exchange-traded funds (ETFs) that trade for free. Schwab lead the charge by offering free trades on their ETFs. Vanguard, Fidelity, and TD Ameritrade followed suit with similar offerings.

And now just this week, FocusShares entered the game by launching 15 of the lowest cost ETFs ever offered in the public markets. (They also trade for free at Scottrade.) You can own the S&P 500 for 0.05 percent annually and no trading costs? What has Wall Street come to? Real value?

This revolution is good news for the everyday retirement investor. Gone are the days of having to sort through mutual fund brochures and Morningstar ratings. Now the big challenge is to analyze the free-trade allure to discover the best ETF building blocks worthy of their retirement dollars.

How should an investor decide which ETF to use? Should free trades trump expense ratios in making such selections? Here are a few things to consider when sorting through your ETF options:

Let purpose trump cost. The purpose an ETF serves in your asset allocation is more important than splitting hairs on cost. For instance, many of our MarketRiders portfolios concentrate on small-cap value stocks in a portfolio, even though these ETFs tend to have higher expense ratios. It is better to embrace the slight fee increase to achieve your desired asset allocation targets than to skip on the proper allocations in search of lower fees.

Understand the key areas of cost. Another important step in analyzing the value of commission-free ETFs is to understand the three main sources of ETF costs.

• Trading commissions. Most of the leading discount brokers charge around $8 to $10 a trade. If you have a globally diversified retirement account consisting of 14 ETFs and rebalance that account four times a year, you are making 56 trades. At $10 per trade, you are adding an annual $560 fee drag on your portfolio’s growth. For larger portfolios, these trading fees become less meaningful, but with smaller portfolios these fees can become significant. For example $560 in trading fees on a $500K portfolio represents less than .11 percent annually. On a portfolio of $50K, this annual burden dramatically increases to 1.12 percent.

• Fund expenses. While ETFs are run by sophisticated computers and have attractively low fund expense ratios, not all ETFs are created equal. When you look at the common indexes for U.S. large-cap stocks as supplied by the leading ETF providers, the fees vary slightly. Vanguard’s S&P 500 ETF (symbol VOO) costs 0.06 percent, while Schwab’s U.S. Large-Cap ETF (SCHX) costs 0.08 percent, State Street Bank’s SPDR S&P 500 (SPY) costs 0.09 percent, iShares S&P 500 Index (IVV) costs 0.09 percent, and now FocusShares Morningstar Large Cap ETF (FLG) costs 0.05 percent. A $100,000 investment in SPY versus FLG will differ a mere $40 annually because of their expense ratios. This is probably not a big reason to choose one ETF over another. The fund expense-ratio story can change, however, when you move into more specialized indexes. Take the emerging market index, for instance. While Vanguard offers MSCI Emerging Markets ETF (VWO) at 0.22 percent, Schwab offers its Emerging Markets Equity ETF (SCHE) at 0.25 percent, State Street offers SPDR S&P Emerging Markets (GMM) at 0.59 percent, and iShares offers MSCI Emerging Markets Index (EEM) at a whopping 0.69 percent. It is not surprising VWO just trumped the long standing emerging market leader, EEM, in assets under management, with an expense ratio differential of 0.46 percent and a great history of tracking the same index with excellence.

• Bid/ask spreads. While trading costs and expense ratios are easy for investors to understand, they often overlook a third cost: the bid/ask spread. The “ask” is the market price at which an ETF can be purchased and the “bid” is the market price at which an ETF can be sold. The bid/ask discussion can quickly become highly technical, but what investors need to know is that ETFs with lower volumes tend to have larger spreads, which essentially becomes another type of transaction cost. An ETF can trade for free, but because the ETF has poor volume, or weak market maker competition, the bid/ask spread can cost as much as the trading expense on larger transactions.

So what is the answer? Is it better to construct your retirement portfolio with commission-free ETFs offered at your broker, or to choose ETFs with the lowest expense ratios, or look at volumes and bid/ask spreads? Even with the three variables above, the answer becomes a very personal one that requires a bit of thought. How often will you trade? How much money is in your portfolio? Who’s your broker?