The answer to this question is both of paramount importance to any investor who wants to decide whether to invest in an exchange-traded fund (ETF) and also very difficult to answer without too much qualifications. This is due to the fact that ETFs, much like any other investment option, both have explicit and implicit costs attached to them. Which of these is most important, and which is of less significance, will depend on the specific goals the investor wants to achieve through their investment.
The first explicit costs that any ETF investor will encounter are brokerage fees. ETFs are bought and sold on an exchange much like stocks themselves. This means that the same costs apply as would be in the case of stock buying, rather than the front-loading model typical for mutual funds. Most retail brokers today offer a basic flat rate for a trade, which is valid up to a certain number of shares, after which the fees will increase linearly.
The expense ratio of an ETF is the percentage of its value which will be deducted yearly due to all expenses incurred during the management of the fund, such as the fund manager’s salaries, the trading costs and marketing and accounting expenses. It will be low for stock index funds and higher for commodity ETFs like a copper ETF or the funds in this uranium ETF list. This deduction naturally leads to a continuous deviation from the performance of the index underlying the ETF, which will in the ideal case need to be compensated by a similar over-performance of the actual holdings of the fund relatively to the index.
This deviation gives rise to a final important implicit cost of an exchange-traded fund, its tracking error. Many investors will agree that this is actually the most important parameter to judge a fund’s performance, especially in the long run. The tracking error is defined as the standard deviation of the fund price from the underlying index value and is therefore indicative of the true deviation of an ETF from its stated goal of tracking the index. It may be due to several reasons apart from the expense ratio and can become very significant for any niche index funds and especially futures-based ETFs.
All together, any of these three costs must be carefully analyzed by a potential investor before making a final decision in favor of an investment in a specific exchange-traded fund.