ETFs are a type of investment that tracks an index or group of securities, and you can trade them on an exchange similar to trading stocks. When you invest in an ETF, you need to pay management fees to the brokerage that manages your ETF. So, why do ETFs have management fees?
ETFs have management fees to pay for brokers’ expenses managing the fund, like staffing, account management, and other investment management costs. Management fees are deducted from an ETF’s earnings, so a higher fee means you’ll get less money from your investment profits.
This article will explain what ETFs are, how ETF management fees are calculated, and how ETF fees affect the return on your investment. You can also use the resources I suggest in this article to learn more about ETFs and management fees, so keep reading.
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Why Do You Pay Management Fees for ETFs?
ETFs, or exchange-traded funds, are securities that track various assets, indexes, and sectors. They can track a single asset or a group of securities like stocks and bonds.
ETFs are traded just like stocks. They’re traded on an exchange, with prices changing throughout the day, depending on the market. Each fund is made up of different securities, which all affect the price of the ETF.
Some benefits of trading ETFs are that they’re diversified, have a better chance of a return, and have lower fees than other investments.
You have to pay management fees for ETFs because your brokerage manages your investments. Essentially, charging fees for managing your ETF investments is how your brokerage makes money. The fees cover anything that helps your brokerage operate, from staffing to marketing expenses.
Compared to mutual funds, which are actively traded investments, ETFs tend to have lower fees. ETFs are passively managed investments since they’re just tracking the value of their securities, and passive funds have lower fees than active funds.
The actively managed funds have investors constantly watching the securities within them and changing the fund’s capacity. Therefore, they have higher operating costs and higher fees.
Fees also vary depending on the type of ETF and what securities are a part of the ETF. International ETFs are more expensive than other types because they require international employees and research.
The next section explains how the management fees are calculated, how management fees change over time, and how the management fees will affect your return.
How Are ETF Management Fees Calculated?
ETF management fees are calculated based on the expense ratio of the investment. The expense ratio is calculated by dividing the total investment cost by the total investment assets and is usually between a fifth of a percentage and one percent.
Expense ratios for ETFs are low compared to the expense ratios for mutual funds ranging from half a percent to two percent.
The expense ratio is calculated every year, and you can find it before you choose to invest in an ETF. The expense ratio should play a part in your investment decisions since it’ll affect your earnings.
If you’re researching ETFs, you can find the expense ratio on financial websites. You can also compare expense ratios for different ETFs if there are major differences among different ETFs or brokerages.
Management fees compound, so if you hold your ETF for more than one year, you’ll need to pay the management fees for multiple years when you’re ready to sell your investment. The expense ratio will change annually, and your brokerage will alert you of the newest expense ratio each year.
If your ETF has a price or expense ratio increase, and you hold the ETF for more than one year, you’ll pay more in management fees even if the expense ratio doesn’t change. The increase is because the percentage of the price is higher.
Even if your ETF doesn’t have a return, meaning a zero percent return, or a negative return, you’ll still need to pay management fees on the ETF.
It’s important to pay attention to the management fees of an ETF because they’re deducted out of the return on your investment before you are paid.
How Do ETF Management Fees Affect Your Return?
ETF management fees affect your return when the fees are deducted from your investments before payouts are given to you. The higher your returns, the higher your fees. Still, ETF management fees are much cheaper than actively managed mutual funds. That’s because ETFs are passively managed.
The amount that you’re paid out is called the Net Asset Value, or the NAV. According to Investopedia, the NAV is the net value of an entity. It’s calculated by deducting the total value of its liabilities from the total value of the entity’s assets.
For ETFs, the NAV is calculated by taking the price of the ETF and subtracting the management fees. As a reminder, the management fees are equal to the expense ratio, so the NAV is equal to the ETF price minus the expense ratio.
For example, suppose you invest in an ETF for one year with a twelve percent return. If the expense ratio is one percent, you’ll receive a NAV, or payout, of eleven percent after the management fee is deducted.
While an ETF with a low expense ratio may seem like an obvious choice over one with a higher expense ratio, there are a few other things you should consider before choosing between them.
If you’ll hold an ETF with a low expense ratio for multiple years but a high expense ETF for only one year, the total fees you pay may be lower on the high expense ratio ETF.
You should also consider the price of the ETF. The higher the price, the higher the management fees. However, higher prices could also mean the ETF has higher earning potential.
ETF management fees are charged annually, so they can add up if you hold an ETF with a high expense ratio over multiple years. For example, say you hold an ETF for five years, and the expense ratio is one percent. Every year, you’ll need to pay one percent of the return for the management fees.
Learn More About ETFs
ETFs are a good investment for your portfolio, but you need to understand the costs and risks of investing in them and choose an ETF that will work the best for you. Here are some books and videos you can explore today to help you understand ETFs and how to invest in them effectively.
This video from TD Ameritrade on YouTube will teach you the basics of investing in ETFs and what the risks and rewards of investing in them are:
To learn how you pay for the expense ratio when you invest in an ETF, check out this video from ETF.com:
David Schneider Index Funds & ETFs (available on Amazon.com) will teach you how to invest in ETFs that are best for you, your trading style, and your goals. The book has the basics of ETFs, making an ETF investment plan, and avoiding the risks of investing in ETFs.
Author’s Recommendations: Top Trading and Investment Resources To Consider
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Conclusion
Management fees are charged on ETFs, so the brokerage that manages your ETF can pay for the costs of running your investment. The management fee will change annually, based on the expense ratio, and the fees will compound for each year that you hold the ETF.
Different ETF types and brokerages charge different fees, and the management fees come directly out of your return or NAV, so you need to consider the cost of management fees when choosing an ETF.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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