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.
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.
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.
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."