How to analyze an ETF’s total cost of ownership

• The total cost of ownership (TCO) is more than the expense ratio. Because an ETF can be bought and sold on an exchange like a stock, you must also factor in trading costs.
• The lowest expense ratio doesn’t always translate into the lowest total cost fund.
• Liquidity and bid-ask spreads can matter as much as headline fees—especially for frequent traders.

When you book a flight, your eyes naturally gravitate to the ticket price. As much as you might hope that the fare you see is what you’ll pay, that’s wishful thinking. Baggage fees, seat upgrades, and transportation to the airport add to the total cost.

ETFs work the same way. The expense ratio is the headline number, kind of like the base fare. But it doesn’t tell the full story. The total cost of ownership (TCO) for an ETF includes its ongoing expenses and the costs associated with buying and selling it. Other factors, including tracking error (how closely the fund follows its index) and taxes can also affect returns.

Why expense ratios don’t tell the whole story

Like the base fare on a flight, the expense ratio is a starting point for your research. It’s an important reference point, but to understand your true costs, you need to look beyond it.

Holding costs are what you pay to own the fund, usually by paying the expense ratio. Transaction costs are what you pay to trade it (bid-ask spreads, commissions, and rebalancing costs, or in other words, the costs from buying and selling securities inside the fund). Both matter, but which matters more depends on how you invest.

• For long-term investors, holding costs tend to matter more

• For frequent traders, transaction costs can have a bigger impact

Because ETFs trade like stocks, your ETF’s total cost also includes:

• Bid-ask spreads: Every time you buy, you pay the “ask” price. Every time you sell, you receive the “bid” price. The difference between the two is known as the spread, and it’s a trading cost. Wide spreads eat into returns, particularly for large and frequent trades. Rule of thumb: securities with higher trading volumes typically have tighter bid-ask spreads.
  
• Brokerage commissions: Many platforms advertise commission-free trading, but commissions still apply on some brokerage platforms, and they can reduce your returns.
• Taxes: In taxable accounts, buying and selling securities can trigger capital gains and create tax consequences. Funds with lower turnover (how often they buy and sell holdings) may be more tax-efficient, even if their expense ratios are slightly higher. To evaluate tax efficiency, start by looking at a fund's turnover rate.

Beyond costs, investors should also consider how closely an ETF has tracked its benchmark. While some differences are expected due to fees and portfolio management, consistent deviations from the index may be worth examining.

The role of bid-ask spreads and liquidity

Imagine a busy airport hub. With flights constantly arriving and departing, it’s easy to make a quick connection. At a small regional airport, it’s a different story. Connections are fewer and farther between. You may have longer wait times or pay more for the seat you want.

That’s where bid-ask spreads come in. 

Bid-ask spreads are the gap between what a buyer is willing to pay and what a seller will accept. Every time you trade, you pay that gap. In a liquid ETF, buyers and sellers meet in the middle quickly, so the spread is narrow. In less liquid ETFs, or when markets are volatile, the gap widens. 

A lower expense ratio does not necessarily mean lower trading costs. As Figure 1 shows, funds with similar expense ratios can have very different trading costs, underscoring why you should look beyond a fund’s expense ratio.

Bid-ask spreads can widen during periods of market stress, as seen during the COVID-19 sell-off and the 2023 regional banking turmoil. That can make even low-fee funds more expensive to trade.

Liquidity is another important driver of trading efficiency. An ETF's liquidity reflects both the market for its shares and the liquidity of its underlying securities. More liquid ETFs typically have more buyers and sellers, which can help keep bid-ask spreads narrow. As Figure 2 shows, heavily traded ETFs generally cost less to trade than lightly traded ETFs.

How to evaluate an ETF’s total cost

Expense ratios are a useful starting point, but they don’t tell the full story. Trading costs, liquidity, and how closely a fund tracks its index all play a role in what you actually pay for an ETF.

Before investing, consider these key questions:

Looking beyond the expense ratio to evaluate the total cost of ownership can help you make more informed decisions and keep more of what your investments earn over time.