Economic ETF trade size cost considerations


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Economic ETF trading size considerations

This article discusses some considerations regarding efficient ETF trading and economic trade sizes. At the end of this section, you will also find two tables on ETF brokerage and trading cost amortization over 1, 3, 5, 10, and 20 year holding periods. There is one table on do-it-yourself ETF discount brokerage cost amortization, and another table on full service broker assisted ETF brokerage cost amortization.

Low cost ETF funds do not specify a minimum investment. This is simply because the minimum cost required to invest in an ETF is the current market price of a single ETF share plus the brokerage and bid-ask spread trading costs for executing the order.

Since ETFs are traded on securities markets like shares of stocks, ETF purchase and sales brokerage and trading costs should be considered carefully. These ETF brokerage and trading costs are in addition to the management expense ratio of the ETF and its other costs, such as the portfolio turnover trading costs that occur within the fund.

Mutual fund and ETF shareholders bear different costs

As mentioned in other articles on this website, mutual funds and ETFs both incur portfolio management expenses and portfolio turnover trading costs within the fund. They differ with respect to the purchase and sale of shares in the fund. A mutual fund incurs the costs of buying and selling related to the funds of shareholders entering and exiting. After inflows are netted against outflows, mutual funds will have incremental trading expenses related to these net daily shareholder flows.

Therefore, all fund mutual fund shareholders must bear these trading costs, even if they are inactive buy-and-hold investors. This is another reason for passive investors to favor boring and non-sexy no load index investment mutual funds, because they have very low turnover in the portfolio. Furthermore, their shareholders tend to me more stable and committed to a long-term buy-and-hold strategy and tend to own their shares much longer.

One of the advertised virtues of ETFs relative to mutual funds is that ETFs can shield the passive investor from the trading costs of active investors, since ETF shareholders bear their own trading costs. However, if you are really going to capitalize on this potential ETF advantage, then you need to ensure that your trading costs really actually are lower than they would have been if you were to have held low cost passive mutual funds instead.

It is very important that you understand what your mutual fund versus ETF trading cost benchmarks should be. Since you can buy very low cost no load index mutual funds with very low turnover and since these funds are quite expert at managing their trading costs, then these funds are the relevant trading cost comparison benchmarks for your individual ETF trading activities.

When the cost of share trading shifts to you via ETF investing, you need to consider:

Buying in a sufficiently large order size and using do-it-yourself trading via discount brokers can allow you to keep your trading costs sufficiently low. Holding your ETF investments for a very long period will allow you to amortize the brokerage fees that you must pay and in effect lower your annual ETF trading costs.

You should note that some of the lowest cost ETF vendors have already realized that brokerage costs are a very significant issue, and they have already taken action. These very low cost ETF vendors have made arrangements for commission-free ETF trading when you deal directly with them through their in-house brokerage accounts. Investigate whether you can take advantage of commission free trading with these vendors, because commission free trading is another very strong reason to favor certain vendors who already offer ETFs that have the lowest portfolio management expense ratios.

The economics of ETF brokerage costs work against frequent small investments

The economics of ETF brokerage costs favor the accumulation of a reasonable amount of cash and works again frequent small investments. Nevertheless, do not get too carried away with accumulating large blocks of cash for ETF purchases. Investment risk premiums are the economic rationale for investing. If your cash is not deployed in stock or bond ETFs, then these market risk premiums are not available to you, when you are on the sidelines in cash for the parts of your portfolio you intend to deploy in stocks and bonds.

Properly analyzed, ETF brokerage costs involve the combined “round trip” brokerage cost of buying a position plus the cost of later selling that same position. In addition, trading costs should include the portion of the securities market bid-ask trading spread that you must pay, as well. In the tables below, I assume that your trade execution costs will be neutral, and that you will pay a full bid-ask spread for a roundtrip ETF buy and sell transaction.

The full bid-ask spread means that you would pay one-half of the spread when you buy and the other half of the spread, when you sell. This is probably an optimistic assumption. “Best execution” prices are largely a myth for smaller retail investors. Do you really think that the securities industry is looking out for the price quality of your trades, when trading is a zero sum game?

In the tables below, I have assumed that the size of the total bid-ask spread is .1% for a typical ETF and that you would pay half of the spread buying and the other half selling. For large and well-traded ETFs, this is a reasonable bid-ask spread to assume. In fact, the largest and most highly liquid ETFs have a bid-ask spread of only .02% to .05% in relatively stable market trading.

However, ETFs with a very narrow bid-ask trading spread constitute only a small minority of ETFs. You should be aware that ETFs without very large trading volumes can have very wide bid-ask spread percentages. These wider spreads can dramatically drive up your ETF trading costs. Furthermore, you should understand that bid-ask trading spreads can also increase significantly in volatile markets. In addition, do not even think about trading ETFs after hours, unless you are watching your trading costs very closely. Low after hours trading volume can lead to very wide bid-ask spreads.

 

Table 1 — Discount Broker ETF Trading Cost Amortization (% per year) *

Initial Purchase Amount 1 Year Holding Period 3 Year Holding Period 5 Year Holding Period

10 Year Holding Period

20 Year Holding Period

$500 4.10% 1.37% 0.82% 0.41% 0.21%
$1,000 2.10% 0.70% 0.42% 0.21% 0.11%
$2,000 1.10% 0.37% 0.22% 0.11% 0.06%
$5,000 0.50% 0.17% 0.10% 0.05% 0.03%
$10,000 0.30% 0.10% 0.06% 0.03% 0.02%
$20,000 0.20% 0.07% 0.04% 0.02% 0.01%
$50,000 0.14% 0.05% 0.03% 0.01% 0.01%

* Percentages are total expenses divided by initial purchase amount divided by years held.

Assumptions for the discount broker ETF trading cost amortization table above:

 

Table 2 — Full Service Broker ETF Trading Cost Amortization (% per year) *

Initial Purchase Amount 1 Year Holding Period 3 Year Holding Period 5 Year Holding Period 10 Year Holding Period 20 Year Holding Period
$500 20.10% 6.70% 4.02% 2.01% 1.01%
$1,000 10.10% 3.37% 2.02% 1.01% 0.51%
$2,000 5.10% 1.70% 1.02% 0.51% 0.26%
$5,000 2.10% 0.70% 0.42% 0.21% 0.11%
$10,000 1.10% 0.37% 0.22% 0.11% 0.06%
$20,000 0.60% 0.20% 0.12% 0.06% 0.03%
$50,000 0.30% 0.10% 0.06% 0.03% 0.02%

* Percentages are total expenses divided by initial purchase amount divided by years held.

Assumptions for the full service broker ETF trading cost amortization table above:

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