Tricks of the Trade

Low expense ratios clearly make ETFs attractive for a low-cost, long-term core portfolio but what about trading costs?

Ben Johnson 6 April, 2010 | 3:44PM

There is little question that low expense ratios make ETFs attractive building blocks for a low-cost long-term core portfolio, but what about the price of admission? In order to get a better sense of the total cost of ETF ownership investors need to understand the costs involved in trading ETFs.

Between a Solid and a Gas, We Have…
..Liquid. But for our purposes we will not be discussing water--nor ice, nor steam for that matter. Rather, we are concerned with investments. Securities are often described as being liquid (or illiquid), but what exactly does this mean? Liquid securities are very cheap to trade and it is always possible to find a buyer or seller for them. These assets, such as shares of mega capitalisation equities like Royal Dutch Shell, change hands rapidly and individual transactions have a minimal effect on the going market price. Illiquid assets are starkly different from their liquid cousins. They typically have fewer buyers and sellers. Furthermore, buyers and sellers might diverge substantially on their opinion of a fair price, making the notion of a "market price" murky at best.

But the differences do not have to be so extreme; liquidity is a continuum. Even frequently-traded individual corporate bonds tend to have less liquidity than the shares of that same company, because there are frequently one or two classes of stock versus dozens of different bond issues. Shares in a small-cap firm, even though they are quite easy to buy or sell over time, would look relatively illiquid compared to giant-cap stocks or gilts if you tried to buy a large order off the exchange in one go.

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About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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