ETFs: The costs explained

19th July 2010

We have looked at How to build a winning portfolio using just ETFs but one area we didn't explore was the cost. There has been an interesting discussion on the Money Saving Expert forum about this, which suggests that there is some confusion about how it all works. Hopefully the following will give you a better idea.

In case you missed it the original question raised by scarletjim it was as follows: "Say I bought £100k of a FTSE100 ETF at 4900 and sold at 5100 a week later, then I make that a 'gross' profit of about £4,080.

"Then if you estimate broker fee of £12.50 per trade, that's £25. And if the annual mgmt charge is, say, 0.4%, does that mean pro rata, so in my example £100k x 0.4% x 1/52 = £8?

"So costs are almost nothing! Although presumably I'd have to pay CGT if I exceeded my annual CGT allowance?

"Could I set off losses against profits if I did such a transaction regularly? Am I missing something here in terms of costs or tax?"

Let's break this down and see how it all works.

Broker's fee

You buy or sell ETFs via a stockbroker in exactly the same way as you would when investing in shares. Each time you trade the broker will charge commission.

This is normally a flat rate per transaction and would typically be something like £10 to £20.

No stamp duty

There is no half percent stamp duty when buying ETFs traded on the London Stock Exchange even if the underlying product tracks UK share prices like the FTSE 100 ETF mentioned by scarletjim.

Market spread

ETFs are priced continuously throughout the day so investors can buy or sell them whenever they want.

As when trading shares there will normally be a difference between the bid price ─ the highest price a buyer is willing to pay ─ and the ask price, which is the lowest price a seller is willing to accept.

This bid-offer spread is where the market makers make their money and represents another cost of the trade.

As turbobob says on the Money Saving Expert forum, the bid-offer spread is mainly a function of volume, so the more an ETF is traded the tighter the spread.

The spread can also be affected by the nature of the underlying assets. Typically an ETF tracking an illiquid index of Emerging Market shares will have a higher spread than one tracking a liquid area like the FTSE 100.

One other point to be aware of is that the spreads vary throughout the day and according to the prevalent market conditions.

They are normally wider in the first few minutes after the stock exchange opens before the real volume starts to kick in.

Most spreads also widen when the market is falling heavily to reflect the extra risk being borne by the market makers.

Farley  Thomas, Global Head of ETFs at HSBC, says that ETFs are very different in design to traditional funds. "Typically there is very little trading in an ETF since any subscriptions are handled by way of a transfer of stocks into the fund and the reverse happens for redemptions.

"In a traditional fund, cash comes into the fund and the fund manager has to trade in order to convert the cash into stocks and vice versa.

"This means that as a rule of thumb, the trading costs in a traditional fund are much higher, especially if there are a lot of subscriptions and redemptions."

9 thoughts on “ETFs: The costs explained”

  1. Anonymous says:

    Shaun,

    if  democratic control of economic policy-making is ever restored, you will have my vote as a replacement for Mr Posen on the MPC

  2. Drf says:

    Well of course Posen is an American citizen who does not understand the differences in the UK economy to that of the USA. As such he is like Branchflower a totally unsuitable person to be a member of the MPC. He was chosen principally for his left-wing leaning, as being likely to support the usual left-wing dogma of reckless public spending, and quasi-“Keynesianism” (i.e. excessive public spending on the downside of recessions with no fiscal repayment on the upside following economic cycle). He seems to be wanting to be able to use the UK economy to experiment with parametric economic relationships which he does not understand, learning as he goes along; this would avoid him having to suffer the pain and destruction which would result from his experiments if conducted in the USA.

    However, I still believe that at present all of this is hot air! I still believe that Brown used the escape clause which he wrote into the original MPC remit, to take back control of base rate, and that it was he that authorised the MPC to front QE, since in fact it had never been given any formal authority to undertake any such action; he did this when the UK economy began to get out of control due to his own profligacy. (The MPC was only ever formally given one control tool in its remit – to set base rate.) I believe it has suited Osborne and the present government to leave control in this mode as Brown left it. To support this they allow and probably encourage MPC members to make speeches and write articles about issues like this, to form a smoke screen and to camouflage the true continued position of control.

    This was part of the delusion of Brown. There was never any point in setting up the MPC unless it was to be completely separate from government, and truly independent. It cannot ever be that if this escape clause is still in place and still in force. That was why Brown included it in the remit, and since it was a clandestine action which was not announced he could use it at any time. He was afraid of actually giving the MPC independence, since he knew it would have limited his ability to balance his inevitable overspending via inflation. So in reality the MPC has never had true independence, and the escape clause enabled governments to continue with their old tricks of using inflation as an insidious form of stealth tax. That is what they are doing now with their huge government debt, and QE which will not be redeemed has become part of that increased stealthy theft.

    1. James says:

      you have unfortunately put your finger on why they will not go for elected members of the MPC- they are afraid of what it might do if really independent and had a democratic mandate.

      When the history books are written, will GB go down as the most devios as well as the worst ever prime minister?

      1. guest says:

        In fact, I don’t think that any feasible structure of the BoE can be truly independent; the truth is that there can only be one boss, a political one. Same applies to the OBR.
        Pseudo-independence is a waste of time and worse, some people believe it!

  3. Vegetarian says:

    The basic problem is that economics is a descriptive rather than a predictive discipline. It proposes explanations for the interrelationship of various factors and describes why, looking at past data, one thing led to another. However that is very different from being able to say what will happen going forward given the data today because any such predictive model needs to capture how investors and consumers react to events and that is impossible, even paradoxical. Failing to understand this, we’re left with people like Gordon Brown, Adam Posen and endless others behaving like the pidgeons in B F Skinner’s famous experiment where every movement of the data in their favour is taken as a success and every adverse move is ignored, explained as a random fluctuation or just called shear bad luck. Human psychology is not going to change quickly so were stuck with this. However I can’t see how electing MPC members would improve matters. The real question that throws up is who the voting population should be. The general public? Most people have a limited grasp of economics and almost no idea of relevant macroeconomic statistics (or the MPCs poor record on meeting inflation targets). I get exasperated at how many people don’t even understand the difference between the deficit and the debt and that improving the former only slows the rate at which the latter is growing. Or try explaining to the guy in the pub who just wants his mortgage rate to stay low that keeping the base rate low may result in his mortgage costs spiralling upwards if investors lose confidence in the BOE’s commitment to control inflation. So i don’t see that the public are in any position to assess and select “better” MPC candidates even if they could be bothered to actually vote in the first place. Alternatively if the voters were MPs they would favour MPC candidates who met their short term political requirements eg the governing party would always like lower rates in the year or two before elections. If it were some list of finance professionals they too would have their own self interest agenda too (as we continually see with the behaviour of bankers). Maybe there is some impartial & wise grouping which could be trusted to select MPC’s composition but it’s not obvious to me who they are. We may also have the unedifying site of MPC candidates wasting time running campaigns and generally trying to pander to whatever prejudice they need to stay popular.

    1. Anonymous says:

      Hi Vegetarian

      Welcome to my blog

      You make some very valid points. I studied econometrics for some time and by the time you allow for confidence intervals etc. your confidence in it predicting anything declines a lot…

      As to the system of electing the MPC I remain of the view that it is one for the electorate as a whole. There is no sub-group which has demonstrated the necessary honesty and integrity and intelligence required to get the role so it is time for some proper democracy. As to your point that they are likely to behave like politicians I have two replies. These days they already are behaving like that and differently to politicians who are elected for and on a lot of different issues the MPC would be elected on at most a few and often on only one.

      Perhaps I have more faith in our electorate….

  4. Anonymous says:

    Hi Shaun
    Very interesting, but I think you should consider Mr Posen’s position as he sets it out in his Bruegel papers – post crisis divergence between US and European macroeconomic policies. There you have warning shots in relation to how tightening this side of The Pond could re-bound that side of The Pond and vice versa. He seems convinced that tightening here would lock in sub potential growth and undermine  policies, past present or future. So, there is a call for a ” critical quantum of coordination” with IMF as umpire. It all tracks back to the Posen view that unless his view is adopted sub potential growth will be locked in here for a very long time. It adds up to a warning of beggar-thy-neighbour if the three blocks of US, Eurozone and UK diverge.Apologies if this was mentioned in his article, which I havent read.

    1. Anonymous says:

      Hi Shire
      No problem as it was not. His opinion piece ironically had a title that I agree with, we should not be raising interest-rates now. For newer readers I would not be raising them now because I would have done so some time ago as I first suggested it on this blog back in November 2009. This would have meant that the impact would have helped us with our current and recent inflationary problem.

      You are reminding me of yet another theoretical outpouring from him and so many different types of these which just get abandoned if they stop giving him the answer he wants. This happened for example with the CPI-Y and CPI-CT inflation measures. For a man who in recent years has got so much wrong he seems immune to self-doubt.

      Is that the same IMF whose austerity plans are currently doing so badly in Greece Ireland and Portugal?

      I think in the end it comes down to a fundamental issue. Either you believe that individuals drive economic growth and that governments can help but are not the drivers of it or you believe like he does that he can twist a lever and growth will come..When he did twist the lever with QE we got more inflation than we got growth, but that does not seem to worry him much.

  5. CC Aitch says:

    Alarmingly, Posen (like “the undead” Blanchflower who just won’t go away) appears like a lunatic in charge of our very own asylum. With seemingly no humility or recognition of  his appalling track record of forecasting, he remains certain in his predictions and  decisions.

    It’s frightening that we have essentially unaccountable people like him in such powerful positions and who seem set on pursuing dangerous and failed policies to the point of destruction – quite possibly our destruction. What amount of evidence does he need to see to admit he’s wrong? Seemingly no amount will suffice – he’s become completely wedded to his position, regardless.

    Yikes.

Leave a Reply

Your email address will not be published. Required fields are marked *