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Watch out for the hidden costs of ETFs

by , 29 October 2013

Exchange traded funds (ETFs) help you gain broad exposure to a market or a sector. And their charges are much lower than actively managed funds. However, even within the world of ETFs, you have to watch out for hidden charges. Read on to find out the hidden costs you should watch for with ETFs…

If keeping costs down is one of your goals, then it’s worth comparing different ETFs to see which one offers the most efficient way of tracking your chosen index.

That’s not always as straightforward as it should be, Matthew Partridge in MoneyWeek explains...

Management charges and the total expense ratio (the combination of management and admin costs) are usually easily available. But these are not the only potential costs you should be concerned about.

European ETF provider Lyxor points out that there are three other criteria that affect efficiency.

3 criteria to check on an ETF before investing

One is the liquidity ‘spread’ (sometimes known as the bid offer spread). This is the gap between the buying and selling price of an ETF.

Since you pay slightly more to buy an ETF than you would get if you immediately sold it, the bigger the spread, the higher the cost.

Most popular ETFs are extremely liquid, with plenty of buyers and sellers, and so have low spreads.

However, the more lightly-traded products tracking more obscure indices often suffer from higher spreads. Also, even within sectors, you may well find that a more popular ETF offers tighter spreads than its rivals.

The next two costs are the tracking difference and the tracking error. These measure the extent to which the ETF actually follows the index it is supposed to track.

The tracking difference is the absolute divergence. In comparison, the tracking error is the volatility of the tracking difference over time.

While divergence can lead to the fund beating the market by a small amount, most funds end up slightly underperforming. In any case, if you’re buying the fund for a specific reason, it complicates matters tremendously if it behaves in an unexpected way.

So there you have it, the hidden costs you should watch for with ETFs.

Watch out for the hidden costs of ETFs
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