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How to Calculate the True Cost of an ETF

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ETFguide.com provides you with a three-part formula for determining cost.

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Almost everybody knows that exchange-traded funds (ETFs) have rock bottom fees. But an ETF's annual expense ratio is not the only cost. Nor does everyone – even those in the same exact fund - pay identical cost.

Before we examine one smartly designed formula for estimating ETF costs, let's analyze the three inputs used in the calculation:

Operating Expense Ratio (OER)
This is the ongoing cost that an ETF charges to shareholders for managing the portfolio. Most ETF OER's are reported in percentage terms and funds that charge less than 0.25% are easy to find. The OER is the most important cost factor for long-term investors or those holding the fund for longer than a year. For newly launched ETFs, beware of temporary fee waivers which the OER for a specified period of time. Fund managers use this as a selling tool to attract new money. Here's the problem: After the fee waiver expires, ETF expenses can shoot higher.

Bid/Ask Spreads
The bid/ask spread of your ETF's share price may widen considerably, thereby increasing your trading costs. The bid/ask spread is the difference between the lowest seller's ask price and the highest buyer's bid price. Generally, ETFs with significant daily volume like the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) will have tighter bid/ask spreads compared to ETFs with less volume. For active ETF traders, the frictional cost of bid/ask spreads can be more significant than OER.

Brokerage Commissions
Unless your ETF qualifies for commission free online trading, you will pay a transaction fee or commission for each trade placed. Granted, online trading costs have dropped dramatically and executing trades for less than $10 is readily available. But tor investment accounts that actively buy and sell ETFs, brokerage commissions can quickly devour your money. Commissions can also hurt ETF investors who dollar cost average in or out of their investments.

After you've determined which ETFs you want to own, the next step is to estimate their costs. Michael Iachini, CFA, CFP and Managing Director of ETF Research at Charles Schwab Investment Advisory suggests knowing how long you plan to own the ETF and how you will use it inside your portfolio.

Here's a general formula for calculating the annual total cost of ETF ownership:

OER
+ Bid-Ask Spread ÷ years you plan to hold the ETF
+ 2 × dollar commission ÷ $ amount of investment ÷ years ETF will be held
Approximate Cost of Ownership per year

For an ETF with an OER of 0.10%, a bid/ask spread of 0.15%, a six-month holding period, an $8.95 trading commission and a $10,000 investment, the annual total cost of ownership is 0.76% per year. Here's the calculation:
0.10%
0.15% ÷ 0.5
+ (2 × 8.95 ÷ 10,000) ÷ 0.5
0.76% per year

Editor's note: This story originally appeared on ETFguide.com.

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