ETF Investing: Where Cost Counts

As the adage goes, success in real estate depends on three factors: location, location, location. In investing, I think it's safe to say investors who want to improve their returns should focus on three factors: cost, cost, cost. OK, I realize that cost isn't the only component to investment success, but it's an important one.

Investors should appreciate that every penny charged in fees is a penny lost in their investment returns. And pennies can add up quickly.

That's why I like the exchange-traded fund industry. In general, ETFs have low fees, as expressed by expense ratios. Expense ratios essentially are the charges imposed by investment managers to pay for running the funds. All things being equal, the lower your expense ratio, the higher your return.

But investors shouldn't look just at expense ratios and assume that's the end of the story when it comes to costs. Pull back the curtains a bit, and there can be other charges.

Most ETFs are passively managed. That means they track the price and yield performance of an index. The majority of ETFs track indexes developed by third parties. For example, at FocusShares, we track indexes created by Morningstar (Nasdaq: MORN). (But there are scores of other indexes tracked by ETF providers.)

An ETF that tracks an index has one big responsibility: making sure that the fund's returns match as closely as possible the returns of the underlying index. But that job isn't easy. Corporate actions, such as dividend payments or mergers, happen every day. Managers of passively-managed ETFs have to adjust their portfolios quickly and accurately to reflect those actions.

Investors would do well to look at how closely an ETF matches its stated underlying index. Fortunately, it's not difficult to find that out. ETF providers are required to report (and most do on their Websites) the performance of their funds relative to the underlying index. If an ETF isn't measuring up, it could cost you more than pennies.

One potentially big cost to an ETF comes at the very moment you purchase it. ETFs trade on a stock exchange, just like individual stocks. That means they have bid and ask prices -- or the difference in price between buying and selling shares. The difference between bid and ask prices is called the spread. The wider the spread, the more likely it will be that investors might pay a premium for an ETF. So a narrow spread generally benefits investors.

The final significant cost comes with commissions. Whether you're an active trader or a buy-and-hold investor, keeping your trading costs as low as possible is an important objective. A number of ETFs can be purchased commission-free. For example, FocusShares offers 15 Focus Morningstar funds commission-free through a Scottrade brokerage account.

I've been associated with ETFs for about two decades for one simple reason: ETFs provide investors of all sizes with maximum investment options at the lowest costs in the investment world. But you shouldn't just dive into ETFs (or any investment for that matter), assuming you're getting the best investment deal, because even among ETFs there are differences. Small fractions of a percent can add up to big differences in investment returns over time. That's why investors should consider the full cost of all investments before deciding what to buy.

— Erik Liik is president and CEO of FocusShares LLC, a Montvale, N.J. subsidiary of St. Louis-based Scottrade. FocusShares offers 15 domestic equity exchange-traded funds. For more information on FocusShares, go to www.focusshares.com.

[Disclosure: Consider the investment objectives, charges, expenses, and risks of an ETF or mutual fund carefully before investing. A prospectus containing this and other information should be obtained from the issuer. The prospectus should be read carefully before investing. Focus Morningstar ETFs are commission-free for those using Scottrade's online platforms. Investors not affiliated with Scottrade are subject to commission costs. Morningstar is a service mark of Morningstar, Inc. and has been licensed for use for certain purposes by FocusShares, LLC (an affiliate of Scottrade, Inc.). The Focus Morningstar ETFs are not sponsored, endorsed, sold, or promoted by Morningstar, and Morningstar makes no representation regarding the advisability of investing in Focus Morningstar ETFs.]