One of the most appealing features of exchange-traded fundsaside from the ability to tap into a large variety of asset classeshas been their lower costs. Compared to regular mutual funds, ETFs are virtually free, as the average ETF has an expense ratio right above 0.43%. However, some broad stock market and bond indexes can be had for as little as 0.04%. This compares to an average 1.4% for traditional mutual funds. That cost savings has many investors switching over to the fund format [see The Cheapest ETF For Every Investment Objective ].

But what exactly do those fees actually entail? Read on to find out.

Whats in My Expense Ratio?

The costs of owning a fund is called the expense ratio, which is expressed as a percentage of the funds assets. This ratio covers the investment advisory fee, administrative costs, other operating expenses and in the case of mutual funds, potential 12b-1 distribution fees. This is distinct from the costs of actually buying a fund, which involves brokerage commissions.

The investment advisory fee/management fee is the money necessary to pay the manager of the fund. In the case of broad index-hugging ETFs, this fee is usually pretty low as there is basically no “thought” required of the investment manager. Administrative costs are just that they represent the costs of record keeping, prospectus mailings, maintaining a customer service line and website. These also include accounting and other “backroom” costs of an ETF [see also 101 ETF Lessons Every Financial Advisor Should Learn ].

All of these fees are expressed in two ways: gross and net. Gross expenses of an ETF represent the cost of running a fund as compared to the profit earned by the sponsor, while the net expense ratio represents the gross expense ratio minus any acquired fees and waivers/reimbursements. The primary difference between gross and net expense ratios has to do with their impacts on the investor. Gross expense ratios affect only the fund itself, while net expense ratios reflect the amount of money paid by each investor for the fund’s operating costs.

The real difference between the two ratios is basically how much of the operating costs a fund manager is willing to absorb and how much of those costs it charges investors. The expense waiver is the percentage of costs a fund sponsor is willing to eat in order to keep the fund’s net expenses low. Capped expenses are similar in that they represent the maximum a fund company is willing to charge for a set amount of time [see Cheapskate ETFdb Portfolio ].

The Bid-Ask Spread

Aside from the operating costs of an ETF, investors need to be aware of the other fees that could impact their investment. One of the biggest impacts comes from wide bid-ask spreads. Essentially, the bid is the price that someone is willing to pay for a stock, ETF or other investment vehicle at a specific point in time, whereas the ask is the price at which someone is willing to sell. The difference between the two prices is called the bid-ask spread .

In the ETF world, market makers work hard to ensure that funds trade as closely to their net asset values (NAV) as possible; this is one of the hallmarks for the fund-type. Usually, this isn’t a problem for highly liquid funds like the SPDR S&P 500 (SPY, A ) and the spread is usually just a penny or two [see also 10 Questions About ETFs You’ve Been Too Afraid To Ask ].

However, for some very low volume ETFs, wide bid-ask spreads do exist. Those wide spreads can be thought of as a hidden cost to investors. Trading ETFs with large spreads eat away at potential returns since they affect the price at which an ETF purchase or sale is made. Investors may potentially also purchase an ETF above its NAV and be paying a premium for the basket of securities.

There are a few ways for investors to avoid this phenomenon. First, investors should try and stick with liquid funds that trade often. The more shares traded each day reduces wide bid-ask spreads. Secondly, using limit orders which allow investors to sell or buy a certain amount of stock at a given price or betterwill help reduce this issue. All ETFs have a NAV ticker that displays what the actual basket of assets is worth. Finally, focusing on the long term will smooth out any premiums to NAV as your investment grows.

Commission Fees

While the internet age has reduced the fees investors pay to buy/sell stocks and ETFsdown from about $150 a tradethere is still no free lunch when it comes to trading. Most brokerage firms still charge fees when an investor buys or sells ETFs. These fees can stack up if someone is dollar cost averaging or trading a fund position. For example, if you buy the previously mentioned SPY every month to build a long-term core position, those costs could amount to nearly $120 a year assuming you pay $10 a trade. Adding in any additional brokerage account fees for the number of shares and you’re looking at some serious expenses.

However, there are several brokerage platforms that offer commission-free ETF trading. Popular ETFs like the Vanguard FTSE Emerging Markets (VWO, A ) or Vanguard REIT Index ETF (VNQ, A+ ) can be traded for free if you are a Vanguard customer. while account holders at TD Ameritrade can choose from over 100 different commission-free ETFs.

The Bottom Line

While ETFs have driven down the costs for investors, there are still fees associated with adding these financial instruments to your portfolio. Being aware of these various costs that come along with the security is necessary to gain the most from your investment.

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Disclosure: No positions at time of writing.