The Hidden Costs of Commission-Free ETFs

Brokerage firms such as Fidelity, Charles Schwab (NYSE: SCHW) and Vanguard have all launched commission-free exchange-traded fund (ETF) programs. Are commission-free ETFs really as good as they seem, or are you better off paying the commission on traditional ETFs?

Commission-Free ETFs for the New Investor

First, let’s examine the positive scenario with commission-free ETFs.
The benefits of ETFs are clear: lower expense ratios than actively managed funds, easy diversification, and they trade like a stock. The average ETF carries an expense ratio of 0.44%, compared to 0.74% for the average traditional index fund.
For a new investor, the commission-free ETF programs are a good opportunity. Let’s say you are 25 and starting your first Roth IRA. You want to invest $500 each month in five different ETFs to have a diversified portfolio.
If you were paying the typical $8.95 for each trade, that would be about $45 each month, or nearly 10% of your investment. That would be absurd, and completely eliminate any of the benefits of the ETF structure. Commission-free ETFs are certainly a great option for the small investor who invests frequently.

There Is No ‘Free Lunch’

We all know the old saying: there’s no such thing as a free lunch. These firms would not be offering these commission-free ETF programs if there wasn’t a way to profit off them as well.
To evaluate where these profits are coming from I researched Charles Schwab’s commission-free ETF program.Charles Schwab launched its ETF OneSource Program in 2013 with 105 commission-free ETFs for Schwab customers. With more than 200 offerings, Schwab now has the most commission-free ETFs available. E-Trade’s program is the runner-up, but it only has 116 commission-free ETFs available.
One benefit of the commission-free ETF programs is clear: the programs attract new customers.
For years Charles Schwab has been an expert at making money from “free” programs. Schwab is a top player in the no-load mutual fund marketplace, which allows individuals to buy mutual funds without paying a one-time upfront fee called a “load.” Yet according to its second-quarter 2015 SEC filing, the average fee for mutual funds that participated in this “no-load” program was 0.33%.
Where is this fee coming from? Charles Schwab charges the mutual fund instead. It costs a new mutual funds 0.40%-0.45% per year to be in this “no-load” program. That fee is then passed on to you, the end consumer, by the mutual fund rather than Charles Schwab receiving the load.
Charles Schwab makes money in the same way with commission-free ETFs. ETF providers pay a fixed fee up to $250,00 per fund per year to participate in Schwab’s ETF OneSource Program, and an asset fee up to .20% of total assets.
These costs are then passed on to the investor in the form of higher expense ratios.
Let’s do a basic comparison of this higher expense ratio. The median expense ratio of these commission-free ETFs is about 0.35%. The gross expense ratio of the SPDR S&P 500 ETF (NYSEArca: SPY) is 0.11%, and there are even cheaper ETFs available for under 0.10%.
If you invested $1,000 in the commission-free ETF, then you are paying $3.50 in fees versus $1.10. The $2.20 additional expense is still significantly less than the $8.95 commission you would have paid otherwise when you buy and sell the security.
However, if you are investing $10,000 each year, you are now paying an additional $22 in fees each year for the commission-free ETF. In this  scenario, the higher expense ratio quickly becomes more than the commission spent when buying and selling the stock.
If you are evaluating ETFs to purchase, do not let the “commission-free” advertisement lure you into a more expensive investment.
Commission-free programs are great opportunities for someone who is frequently investing smaller quantities, when the commission quickly becomes a large percentage of the investment. However, even that young investor mentioned above will want to reallocate his portfolio to ETFs with lower expense ratios as his or her portfolio grows.
For most long-term investors, paying the commission is a fair trade-off to purchase ETFs with a lower expense ratio.

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