By Ari I. Weinberg
Online brokerages are dangling a new temptation in front of
investors: the near-obliteration of trading commissions. That's
right, buy or sell any stock or exchange-traded fund and pay
nothing!
But investors should think carefully before they take advantage.
What's the problem? For one thing, investors can fall into the trap
of trading too much when they don't have a bill to pay -- possibly
hurting their returns. The market can become an all-you-can-eat
buffet.
"Trading commissions offer an additional behavioral pause," says
Chris Cordaro, chief investment officer of financial adviser
RegentAtlantic in Morristown, N.J. "There are numerous studies
showing that the more investors trade, the worse they perform."
What's more, experts say, free trades aren't as big of a deal as
investors might think. Trading costs have always been minimal
relative to much more important issues, such as how well a fund
tracks its index and the spread between the bid and ask prices when
exiting a fund, they say.
So before taking the bait, here are the key questions that
investors should ask themselves about free ETF trading:
First of all, how did we get here?
For nearly a decade, brokerage firms dangled free trades to draw
investors to their platforms. But these deals were often linked to
an internal or external marketing arrangement with an asset manager
-- so investors had only a limited range of ETFs to choose
from.
The recent offers by Charles Schwab, TD Ameritrade, Fidelity
Investments and others open all ETFs to free trading. It appears to
be a concession to competitive pressures: As the institutional cost
of trading sank ever lower (see chart), it was easier for
competitors such as financial startup Robinhood to offer free
trading at its launch in 2014 or for Vanguard Group to move trading
commissions to zero on most ETFs last summer.
What's the best way to leverage free trading?
It is worth taking a close look at the products you hold to see
if any are a bad fit -- and should be swapped out with no
commission. That is especially true for people who chose ETFs from
the limited pool in the initial round of free-trading offers.
There are a lot of options out there to choose from. Most
broad-based exposures in stock and bond ETFs -- as well as sector,
international and smart-beta funds -- have at least two or three
competing products from different issuers. Expense-ratio
competition has been so fierce that similar funds are coalescing
around the same cost, but security selection and weighting can vary
slightly by breadth and index methodology.
"Investors have to focus on the specific exposure," says Matthew
Bartolini, head of SPDR research for State Street Global Advisors.
"For example, in small-cap equity, there's a significant difference
between the S&P 600 and the Russell 3000."
Another factor to consider: tracking error, which will indicate
how well the portfolio tracks the index and might serve as a basis
for comparison with products on the same or similar indexes. Bear
in mind, some indexes may be harder to track than others due to
security availability and liquidity in small-cap stocks or non-U.S.
markets. Recent and historical tracking error can be found on ETF
issuer and broker websites, as well as third-party research
services such as XTF.com, ETF.com, ETFdb.com and Morningstar.
What are the costs I can't see?
Just because you aren't paying a commission to make a trade
doesn't mean that trading is "free" -- so you should think
carefully before making a lot of moves with your ETFs.
The hidden cost at work here is the trading spread, or bid/ask
ratio, for the ETF. The higher the spread, the more you pay when
you buy and the less you make when you sell. For simplicity, think
about the spread as a cost you pay to exit a trade.
Established ETFs with significant assets and trading have
minimal trading spreads. There are some 1,200 ETFs with an average
bid/ask ratio under 0.25%, according to research firm XTF.com. But
when dabbling in thinly traded ETFs holding less-liquid securities,
an investor can experience spreads above 0.50%.
Free trading "will likely benefit the most liquid funds," says
SSGA's Mr. Bartolini.
What are the other complications of free trades?
For taxable accounts, gains on positions held less than a year
are taxed as ordinary income, while long-term gains are taxed at
reduced rates based on your bracket. So, if you do a lot of
short-term "free" trading, you might end up facing a steeper tax
bill than you expected, warns RegentAtlantic's Mr. Cordaro.
Investors should also think about what they're looking to
accomplish with their trades. If they want to react in real time to
market shifts, then trading ETFs on exchanges may be their best
move. But investors who are mostly looking to rebalance
occasionally might want to stick with mutual funds, which settle
sooner and don't require margin trading.
***
Now that more than 2,000 ETFs are free to trade on so many
platforms, it will be that much easier to hop on investment trends
and fads. But don't let the all-you-can-eat-buffet distract you
from maintaining a healthy diet for your portfolio.
Mr. Weinberg is a writer in Connecticut. He can be reached at
reports@wsj.com.
(END) Dow Jones Newswires
November 03, 2019 22:25 ET (03:25 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.
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