Mutual funds vs ETFs: Which are cheaper? (Part 2)

In Part 1 of this series, I pointed out the ETFs do generally have lower expense ratios that mutual funds. But there is a second, less visible cost to ETFs: the bid-ask spread.

ETFs trade on an exchange just like a stock. This means to buy one, somebody else has to sell one, and sellers never ask for a price that is exactly market value. They always ask for a price that’s just a bit higher, and that’s called the “ask” price. And the ask price is what you pay.

This difference in price between the market value and the buying or selling price is called the bid-ask spread.  In general, this price difference is small — less than a penny — because people are buying and selling a lot of the most popular ETFs. Another way of saying this is that these ETFs have high liquidity.

However, if you are trading unusual ETFs with low quantities of buyers and sellers, the bid-ask spread may be very wide.  The bid-ask spread may also be wide if the component stocks of the ETFs have low liquidity, because the market makers have to incur costs to create new ETFs on the fly.

So what should you do? Just make sure that the bid-ask spread is low as a percentage of any ETFs you buy. Bloomberg Businessweek has a little advice on how to analyze bid-ask spreads.

The upshot of all this: trading commissions, expenses, and bid-ask spreads can all handicap ETF performance.  To reduce ETFs costs, Broker Insider’s advice is:

  • Buy a lot of ETFs at once. You only pay per trade, regardless of the number of ETFs you buy. Monthly “dollar-cost averaging” will only increase your commissions expenses.
  • Buy ETFs with low expenses. Index funds are best. Higher expenses often don’t get you a better portfolio.
  • Buy ETFs with high liquidity. Avoid large bid-ask spreads, which indicate an ETF with low popularity.

By following these strategies, you can invest in ETFs and keep your expenses just a little bit lower than the cheapest mutual funds.

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