Etfs: Commission-Free Investing For Long-Term Wealth

Exchange-traded funds (ETFs) are a great way to build a diversified portfolio. They are similar to mutual funds but trade on an exchange like stocks, which means there are commissions associated with buying them. These commissions, also called transaction fees, usually range between $10 and $20 at most brokerage firms. However, many brokers now offer commission-free ETFs, which can be very beneficial for investors.

Commission-free ETFs eliminate the trading costs associated with buying and selling ETFs, potentially saving investors hundreds of dollars per year. This is especially advantageous for those who buy or sell ETF shares frequently. Additionally, commission-free ETFs allow for more flexible trading, as investors can trade in and out during the day without having to wait until the end of the trading day, as with mutual funds.

However, it is important to consider the downsides of commission-free ETFs. Firstly, only a select number of ETFs are offered commission-free by brokerage firms, which may limit your ability to build a complete portfolio. Secondly, commission-free ETFs tend to have lower liquidity, which can result in a wider bid/ask spread and higher costs for traders.

When deciding whether to invest in commission-free ETFs, it is essential to evaluate your investing goals and carefully consider which ETFs align with those goals. Additionally, investors should be mindful of other costs, such as management fees, which may offset the benefits of commission-free trading.

Advantages of commission-free ETFs

Commission-free ETFs have a range of benefits for investors. Here are some of the key advantages:

No Trading Costs

Commission-free exchange-traded funds (ETFs) offer a significant advantage by eliminating trading costs. These costs can add up quickly, especially for investors who frequently buy and sell ETF shares. By opting for commission-free ETFs, investors can save hundreds of dollars annually in trading costs. This advantage is particularly valuable for active traders.

Cost Efficiency

The absence of commissions makes commission-free ETFs a cost-efficient option. With no extra fees to pay, investors can take full advantage of the minimal expense ratios associated with ETFs. This cost efficiency is further enhanced when investors can build a diversified portfolio using commission-free ETFs, as it allows them to avoid paying any additional fees to brokers.

Day Trading Flexibility

Commission-free ETFs provide the flexibility to trade in and out of ETFs at any time during the trading day. This is in contrast to mutual funds, where investors have to wait until the end of the trading day or even the next business day to complete their transactions. The ability to trade whenever desired is particularly appealing to active traders who want to capitalise on market movements.

Dollar Cost Averaging

Dollar cost averaging is a strategy where investors invest a fixed amount at regular intervals, regardless of the price of the asset. Commission-free ETFs make this strategy more feasible, as there are no trading fees to consider. With traditional ETFs, the trading commissions can quickly erode the benefits of dollar cost averaging, but commission-free ETFs remove this obstacle.

Wide Range of Options

Commission-free ETFs are offered by almost every brokerage firm and fund company. While each firm typically promotes its own proprietary funds as commission-free, there is still a wide range of options available across various platforms. Investors can find commission-free ETFs from well-known providers like Vanguard, iShares, SPDR, and many others.

Disadvantages of commission-free ETFs

While commission-free ETFs have their benefits, there are some disadvantages to be aware of before completely moving your portfolio to only include these.

Firstly, only a select number of ETFs are offered commission-free at most brokerage firms, which means your ability to build a complete portfolio is determined by the ETFs available and whether they fit your desired investment strategy.

Secondly, as with any trade on a stock exchange, there is an ask/bid spread where the middleman makes their money. Brokers often only offer commission-free ETFs with very little volume, meaning they are not very liquid, and investment liquidity is crucial. As liquidity declines, the spread between the ask and bid price widens, which can be costly for traders. If you only trade commission-free ETFs, you could end up spending more money on this spread than you save on commissions.

Thirdly, even if you can technically put together a portfolio using commission-free ETFs, it may not be as well-diversified as a different mutual fund option or a commission-required ETF. For example, your broker might offer a stock index ETF that tracks the Wilshire 5000 instead of the S&P 500, or a US-only bond index tracking ETF instead of a global bond ETF.

Finally, commission-free ETFs are not always the best-performing ETFs. While trading commissions for ETF trades are usually small, the difference in return between two ETFs can be significant.

Therefore, while commission-free ETFs can be a great option, it is important to carefully consider your investment goals and the specific ETFs offered by your broker before deciding to invest.

Liquidity issues

Liquidity is a crucial aspect of investing in exchange-traded funds (ETFs). It refers to how easily shares can be bought and sold without significantly impacting the ETF's market price. A highly liquid ETF enables swift transactions at prices that closely reflect the intrinsic value of the underlying assets, allowing investors to enter or exit positions without encountering substantial price discrepancies or high trading costs.

The primary factors influencing an ETF's liquidity are its composition and the trading volume of its constituent securities. The secondary factors include the ETF's own trading volume and the broader investment environment. Notably, low-volume ETFs are not necessarily illiquid.

The concept of liquidity in ETFs goes beyond the traditional understanding associated with individual stocks. It involves a multitiered framework that encompasses both the dealer and secondary markets. In the primary or dealer market, liquidity is facilitated through the creation and redemption of ETF shares, a process unique to ETFs that helps maintain price stability by adjusting the supply to meet investor demand. In the secondary market, or the stock market, liquidity is gauged by the trading volume of the underlying securities and their bid-ask spread, with narrower spreads often indicating higher liquidity and lower trading costs.

When considering commission-free ETFs, it's important to be mindful of potential liquidity issues. While not paying commissions on trades seems advantageous, the selection of commission-free ETFs offered by brokerage firms may be limited, impacting your ability to construct a comprehensive portfolio. Additionally, commission-free ETFs tend to have lower trading volumes, which can translate to reduced liquidity. As a result, the bid-ask spread may widen, leading to higher costs for traders than the savings on commissions.

Therefore, when evaluating commission-free ETFs, it's crucial to assess the liquidity of the specific ETFs offered by your broker. Ensure that the available ETFs align with your investment goals and enable you to construct a well-diversified portfolio. Remember that liquidity is a critical factor in investment decisions, and understanding the liquidity profile of an ETF is essential for making informed choices.

Tracking the right index

Understanding Index Construction

It is important to know how indexes are constructed and maintained when choosing an ETF. There are two basic types of indexes: those tracking the overall market, such as the S&P 500, and those targeting a specific subset, such as small-cap growth or large-cap value stocks. Indexes can also be based on bonds, commodities, and currencies. Knowing the specific index an ETF tracks is essential for investors.

Diversification and Representation

A well-diversified index ETF can help reduce risk by investing in a wide range of holdings. This diversification ensures that the performance of the entire portfolio is not dependent on a single holding and improves the chances of capturing the next winning investment. Additionally, good indexes reflect the market's sector composition rather than concentrating on a select few, positioning them for stronger risk-adjusted performance over the long term.

Liquidity and Investability

Indexes investing in illiquid securities can be challenging to track and may have limited capacity. Bank loans, for example, trade infrequently and incur steep transaction costs. On the other hand, liquidity indexes weight stocks based on the amount of shares that trade regularly. It is important to consider the liquidity of the underlying securities in an index to avoid high transaction costs and potential capacity problems.

Transparency and Sensibility

A clearly defined index allows investors to anticipate its behaviour across market environments. However, some indexes, such as the S&P 500, are curated by investment committees rather than hard-and-fast rules, which may not meet the transparency standard. Sensible indexes are governed by sound economic rationale. For example, the Nasdaq-100 Index only includes companies with a primary listing on the Nasdaq exchange, which may not make economic sense and can exclude prominent stocks listed on other exchanges.

Performance and Fees

When evaluating index ETFs, investors should consider their performance and fees. While index ETFs offer low costs, it is important to compare fees across different options. Additionally, not all ETFs tracking the same index will perform exactly alike due to tracking errors. Therefore, investors should assess fees, liquidity, and tracking error before making investment decisions.

Other costs

While commission-free ETFs eliminate the cost of trading commissions, there are other costs to consider when investing in ETFs. Here are some important factors to keep in mind:

Fund Expenses: Commission-free ETFs may still have fund expenses, such as management fees and expense ratios, which are annual fees expressed as a percentage of your investment. These fees can impact your overall returns, so it's important to carefully review the fund's prospectus or offering documents to understand all associated costs.

Bid-Ask Spread: When trading ETFs, there is typically a bid-ask spread, which is the difference between the lowest price a seller is willing to accept and the highest price a buyer is willing to pay. This spread can be wider for less liquid or thinly traded ETFs, resulting in higher trading costs. It's important to consider the liquidity of the ETF and the potential impact of the bid-ask spread on your overall returns.

Redemption Fees: Some brokers, such as TD Ameritrade and ETrade, charge a redemption fee if you sell a commission-free ETF within a certain period, typically 30 days. These fees can range from $15.99 to $19.95, depending on the broker. It's important to review the terms and conditions of your brokerage account to understand any applicable redemption fees.

Limited Fund Selection: Brokerage firms usually offer commission-free ETFs for their own proprietary funds or a select list of partner funds. As a result, your investment choices may be limited, and you may not be able to build a fully diversified portfolio using only commission-free ETFs. In some cases, you may need to pay a commission to invest in ETFs that are not on the commission-free list.

Performance and Returns: Commission-free ETFs may not always be the best-performing ETFs available. It's important to compare the returns and performance of commission-free ETFs with other options to ensure you are making the best investment decision for your goals. Consider factors such as historical returns, expense ratios, and the track record of the fund manager.

When considering commission-free ETFs, it's crucial to evaluate all associated costs and how they fit within your investment strategy. While eliminating trading commissions can save you money, it's important to understand the potential impact of other costs on your overall investment returns.

Frequently asked questions