The hidden costs of investing in ETFs

"Performance comes, performance goes. Fees never falter."

• Warren Buffett

We can't all be better looking than average. And there is also no way all active fund managers can beat the market average. It is mathematically impossible.

The aggregate return of all market participants is equivalent to the market return, minus fees. The importance of fees, as a result, is paramount to your success in investing. This is where passive investing comes in - a way to gain broad exposure to the markets at a very low cost - and must therefore outperform most active managers in the long-run. This, too, is mathematically true, and it took the world long enough to realise.

"By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

• Warren Buffett

As a result, there has been a seismic shift out of actively managed investments and into passive funds.

The rise of low-cost ETFs has been a huge boon to investors and are a vast improvement compared to most of the higher-cost stock-picking funds out there. But it is important to understand some of the other harder to measure and more hidden transaction costs involved in investing in ETFs.

We are often fixated on the headline expense ratio when determining in which ETF to invest. This is of course the most immediately transparent fee - it is what you will pay with certainty year-in and year-out when you hold an ETF. However, there are other costs to be aware of:

1. Tracking error

The difference between an ETF's NAV performance and the performance of its underlying index can have some discrepancy. In a perfect world, the return of an index ETF would be equal to its benchmark net of fees. But in the real world, this does not always happen. For example, an ETF does not always mimic underlying indices entirely, as it can be extremely costly to mimic on a stock-by-stock basis if there are thousands of securities in the index. Instead, it invests in a sample portfolio of securities that is supposed to best replicate the underlying benchmark. This generally works fairly well, but we will see large tracking errors during periods of significant volatility or market reversals. Other factors that can chip away at an ETF's performance as compared to its benchmark includes rebalancing costs and cash drag (cash held by the ETF provider as it tries to replicate the ETF's benchmark in the markets).

2. Market bid and offer spread

Like all stocks, ETFs have a market bid and offer price (i.e. bid price is the highest price a buyer is willing to pay, offer is the lowest price a seller is willing to accept). Ultimately, you have to pay the bid/offer spread if you want to cross that spread and complete a transaction. In popular ETFs that are traded with higher volumes (highly liquid ETFs), the spread is fairly narrow, but the less liquid the ETF, the higher the transaction cost you will have to pay.

Understand more: A helpful interview by Vanguard

3. Brokerage and transaction costs

Lastly, a not so hidden but still important cost to watch for is brokerage. One of the advantages of ETFs is that you can trade them intraday like stocks. If you trade ETFs actively (just like other securities), you will incur sizeable transaction costs and negate the low-cost benefits of investing in an ETF in the first place.

The bottom line is that costs matter. One of the advantages of ETFs is that they can be a low-cost way to gain market exposure, but the true cost of investing in an ETF goes beyond the expense ratio.

Total holding cost of an ETF can vary across providers and is more complex than many realize. In many cases, low-cost index funds and unit trusts that have not been getting as much love in the last few years, can be a better option for the intelligent buy-and-hold investor.