Investors have pumped well over $1 trillion into exchange-traded funds, steadily moving their money out of older-style traditional mutual funds and into this investing world darling. It's no wonder: Investors prefer the lower costs, tax savings, and greater flexibility that ETFs offer compared to regular mutual funds. And ETF providers have done everything they can to bolster demand for their products.
But even though financial companies are offering free ETF trading to clients, you need to be aware of both the pros and the cons of their offers before you jump in with both feet.
The Flip Side of 'Free'
One big downside to ETFs is that you've traditionally had to pay brokerage commissions to buy and sell shares. But recently, several online brokers have offered no-commission ETF trading, taking away the last obstacle for many investors who want to incorporate ETFs into their investment portfolios.
As attractive as free commissions sound, you have to read the fine print to be absolutely sure about what you're getting. In particular, here are four things to watch out for with commission-free ETF offers:
1. Not all ETF trading is free. The brokers that offer commission-free ETFs include only certain ETFs on their free lineups. For instance, Vanguard includes its own proprietary ETFs, but if you want to invest in another provider's ETFs, you'll have to pay regular commissions. Similarly, Fidelity, TD Ameritrade (AMTD), Schwab (SCHW), and a host of other discount brokers have made arrangements with various ETF providers to offer their ETFs at no commission. But if you stray from their respective lists, ordinary commission charges apply. So if you decide to open a brokerage account based on a broker's free-ETF offer, make sure that you like the ETFs available at no commission from that broker, or else you'll be in for a costly surprise.
2. "Free" can turn into "fee." Many brokers discourage the use of commission-free ETFs for frequent trading by imposing additional restrictions, such as 30-day minimum holding periods or trading limits. If you violate those terms, then you may end up having pay the regular commission after all -- or even an extra penalty as a short-term trading fee. If you're a long-term investor, those fees won't be a problem. But if you're expecting to buy and sell ETF shares more frequently, then those programs won't help you avoid costs.
3. Commission-free doesn't equal good. In assessing a broker's free-ETF offerings, make sure that the eligible ETFs meet your quality standards. In particular, what you should watch out for are ETFs with relatively high expenses. Even small differences in ETF expense ratios can add up to thousands of dollars in lost returns over long periods of time, dwarfing the savings from avoiding a commission of $10 or less. Stick with brokers that offer high-quality, low-cost ETFs, and you'll be happier with your choice in the long run.
4. Untested ETFs can end up costing more. Another factor in ETF trading that many investors never consider is how much trading volume a given ETF has every day. The most heavily traded ETFs save investors money every time they buy or sell shares, because the higher volume tends to lead to narrower spreads between what you'll pay to buy shares and what you'll get if you sell shares. But many of the ETFs chosen for commission-free treatment are less popular and less liquid, which makes them more difficult to trade and can lead to your having to pay more when you buy and accept less when you sell. For small investors, this is less of a big deal, but if you expect to sink a lot of money into ETFs, illiquidity can cost you far more than free commissions will save you.
Exchange-traded funds do have a lot of advantages, and saving on commissions is just icing on the cake. But be sure you know the ins and outs of free-ETF offers, or else they may end up leaving a bad taste in your mouth.
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