A price war is breaking out in the exchange traded fund (ETF) industry. While it’s not good news for everyone — ETF sponsors, for instance — investors can now get more for their money than ever before! And that makes you the winner of this war.

I talk a lot about the many advantages of ETFs. Very little in this world comes for free, though, and that includes ETFs. The people who design, create, operate and distribute these instruments don’t work for free. Nor should they. But consumers always want value for what they spend, and rightly so.

Today I’m going to tell you a few things about the costs of owning an ETF. As you’ll see, some kinds of expenses are more important than others.

ETF Costs, Inside & Out

The costs of an ETF fall into two broad categories: Internal and external.

Internal costs are the expenses of running the ETF itself. Typically they are paid to the sponsor or other service providers, like lawyers and accountants. These cover things such as management fees, regulatory registration and auditing. Investors never really see these costs because they come out of the ETF assets via the expense ratio of the fund.

External costs are paid separately by investors and are not extracted from the fund. The most common external cost is the commission brokers charge when you buy or sell an ETF.

The good news is that both kinds of costs are falling fast. Why? Part of it is the deflationary economic climate. Wages and many other costs are flat or falling. But the primary reason is growing competition in the ETF industry …

Less than five years ago, at the end of 2005, there were just 224 ETFs and ETNs listed for trading on U.S. stock exchanges. The quantity has more than quadrupled since then hitting 673 by the end of 2007 and 925 last year. So far this year we’ve seen an increase of 130, pushing the total to 1,055.

A few months ago I told you how ETF overload has led to practically identical ETFs from different firms jockeying for a limited audience. And the competition just keeps on growing. I’m sure there will be a shakeout at some point. But for now expenses are one of the few ways sponsors can distinguish their offerings.

For example, just this month Vanguard launched nine new ETFs including Vanguard S&P 500 (VOO). This is a direct attack on the grandfather of all ETFs, SPDR S&P 500 (SPY). SPY alone accounts for about a third of all ETF dollars traded every day. Now VOO is available to cover the same large-cap index at an estimated annual expense ratio one-third lower: 0.06 percent vs. 0.09 percent for SPY.

You might think an advantage of only 0.03 percent a year is negligible. And you’re right. Three basis points on a $100,000 account — which is probably more than most people can or should allocate to any one type of ETF — is only $30.

On the other hand, if you are an institutional portfolio manager with a billion dollars to invest, the difference is about $300,000 a year — enough to buy an exotic sports car.

What about those external costs, especially trading commissions? Well …

Zero Commissions Are Here!

When the price hits zero it is safe to say trading can’t get any cheaper. And that’s where we are — at least for some investors in certain funds.

Three top firms — Fidelity, Charles Schwab, and Vanguard — now have commission-free ETF trading programs. Buy and pay zero. Sell and pay zero. Do it all over again and pay zero. Nice.

There is some fine print, of course. Each program applies only to selected funds. At Schwab and Vanguard, zero commissions are only for their in-house brand of ETFs. At Fidelity, you can trade for free in some of the iShares ETFs as well as the firm’s one proprietary ETF.

There are other restrictions, too. But I’m guessing they will ease over time. ETF sponsors have figured out that their business is now commoditized. One large-cap growth index fund is as good as any other in many cases.

The differences that attract investors relate more to the bottom line after expenses.

f you were actively investing back in the 1990s, you might remember how revolutionary it was when Schwab introduced their “OneSource” no-transaction-fee mutual fund marketplace. I think something similar will develop for ETFs. Furthermore, trade processing, whether stocks or ETFs, is now so automated that the incremental cost for the broker is negligible.

The sponsors affiliated with brokerage firms, like Schwab, will initially favor their own ETF brands. Yet they won’t be able to sustain that model for long. Once investors have a taste for commission-free trading, it will become as expected as free restrooms in service stations.

And if you don’t have it, your customers will go somewhere else.

We’re not to that point yet. Right now you’ll still end up paying for your ETF trades in most cases. However, you can pay quite a bit less if you shop around.

Best wishes,

Ron

Ron Rowland is president and a founder of Capital Cities Asset Management. Mr. Rowland is widely regarded as a leading ETF and mutual fund advisor as well as a sector rotation strategist. In addition to his roles of President and Chief Investment Officer of CCAM, he is Executive Editor and Publisher of the All Star Fund Trader, a highly regarded investment newsletter in its 18th year of publication.

As a former mutual fund manager from 2000 to 2002, Ron was a pioneer in using ETFs inside of mutual funds. He also served as the manager of a hedge fund from Aug. ‘93 to Dec. ‘94. His formal education includes a BS in Electrical and Computer Engineering from the University of Cincinnati in 1978 with additional studies in the same field at the University of Texas from 1978-1981.

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