Vanguard's founder Jack Bogle once said: 'common sense tells us that performance comes and goes, but costs go on forever.' Here are five things you should know about fees before you invest in ETFs.
Lower costs can translate into better performance for investors over time as the higher the fees, the more impact they'll have on investment returns.
So although every investment bears a fee or cost, there are ways to manage them. Below are five things you should know about fees before you invest in ETFs.
1. ETFs generally have lower costs than investing in individual shares
A key reason why ETFs have gained such popularity among individual investors is because they are low-cost and offer access generally to a diversified portfolio that would otherwise be prohibitively expensive to build on your own (although your broker would love you).
Instead of individually purchasing shares, ETFs offer investors a simple way to buy a diversified portfolio covering all the major asset classes (such as shares or corporate and government bonds) through investing in just one ETF. This means only paying one set of brokerage and admin fees, rather than the multiple fees associated with buying multiple individual shares.
2. The NAV is a good indication of the ETF price
NAV stands for Net Asset Value and is the underlying total value of net assets divided by the number of securities on issue. This essentially translates into the value per share. It is a good indicator of how much the ETF is worth and approximately how much you should pay for it.
The closer the ETF is trading to its NAV, the more fairly priced it is.
3. Different ETFs entail different fees
All ETFs come with a set of costs but these costs can vary significantly.
To begin with, all ETFs have management fees that cover the ongoing operating expenses of the issuer (such as admin and recordkeeping costs). These fees are commonly known as the management expense ratio (MER) and are expressed as a percentage of your investments. They are calculated daily and automatically deducted from your returns.
The MER varies between ETFs depending on many factors including the size of the ETF, what index the ETF is tracking (international ETFs may have higher operational expenses) and what the investment strategy is.
MERs are stated in the ETF's product disclosure statement (PDS) and well worth considering before you invest.
Other costs associated with buying or selling ETFs include brokerage fees, which can greatly vary between trading platforms. Sometimes you can avoid paying brokerage fees if there are options to purchase directly from the provider.
While brokerage fees may seem like just a once-off, it's worth factoring in these costs to your investment strategy especially if you plan to invest regular amounts over time.
4. Don't forget tax and capital gains implications
ETFs are generally more tax efficient and realise fewer capital gains than other types of investments (such as actively managed funds) because of their low portfolio turnover. This is because an ETF's basket of shares only changes when the index changes.
Tax implications however do still exist if you make any capital gains when selling your ETFs or if you receive any distributions. Both events provide taxable income and taxed at your marginal tax rate. It's worth noting that if you hold ETFs for more than 12 months, you're only taxed on half of any future capital gains (which is one benefit of a buy and hold strategy).
There may also be different tax considerations if your ETF is domiciled overseas. For example, income generated from ETFs domiciled in the US is considered foreign income.
If you're unsure about what tax implications apply to your individual situation, it may be worth consulting a licensed financial adviser or tax accountant just to be sure.
5. Even a small change in fees can make a big difference to returns
In the same way compounding can exponentially increase your investments over time, it can also exponentially increase your costs. This means that the money you "lose out" on to fees will rise over time if unchecked.
Approximately speaking, a 1 per cent difference in total annual fees and costs (e.g. if your fees were 2 per cent rather than 1 per cent) could reduce your final return by up to 20 per cent over a 30-year period.
Always consider fees and read the ETF's product disclosure statement before investing as costs play a big part in determining your long-term investment performance.