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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