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With ETFs, There Is No Free Lunch

By U.S. News & World Report

Want an inexpensive investment that tracks an index, and you can easily buy and sell during market hours? An exchange-traded fund may fit the bill. Despite being in favor among individual investors and institutions, there are some pitfalls.

Since these investments were unleashed on investors in 1993, their number and variety have exploded. There is an ETF to track just about every market, index, currency, commodity and industrial sector on the planet. According to ETF Trends, “nearly $20 billion per month flowed into ETFs in 2015.”

The reason these things are so wildly popular is they differ from traditional mutual funds in two important ways.

The first is, in general, it costs less to own an ETF than a mutual fund. ETFs have no sales loads or marketing and distribution fees. And, ETFs offer a more tax-efficient investment structure than their open-end cousins. According to Jay Freedman, a tax principal at KPMG, ETFs are structured in a way that defers capital gains until the investment is actually sold. Mutual funds pass gains and income on to investors, who have to pay taxes on those regular distributions.

[See: U.S. News & World Report’s 10 Top-Ranked ETFs.]

So, ETFs offer a couple of distinct advantages over mutual funds. But, don’t be fooled into thinking that there aren’t other costs. After all, there is never a free lunch on Wall Street. Some of the costs of ownership of an ETF are open and straightforward. Others are a bit more opaque. Let’s take a peek.

The most transparent costs of owning an ETF are its management fee and operating expenses. Hey, nobody works for free, right? There are indeed costs associated with having people buy and sell the assets in a fund. Then there are the expenses related to actually running the business. There are real people going into real buildings, sitting at real desks, typing onto real computer keyboards, and talking into real telephones. Each one of those represents real expenses. All of that stuff gets bundled up and fully disclosed in the fund’s prospectus as its expense ratio.

But there are other costs that aren’t quite so obvious.

For example, say you work with a traditional broker who reels in a commission each time he or she shuffles around your portfolio holdings. This type of business model differs from that of a fee-only fiduciary advisor, who has a legal obligation to put your interests first, and isn’t incentivized by earning a cash payment by trading your account. If the kids need shoes or the house needs a new roof, the broker may decide it’s “suitable” to make some trades on your behalf. So, while you may not have considered this when you signed on with a broker, as opposed to a fiduciary, commissions may be an added cost of owning an ETF.

(And if you are currently working with a broker who gets commissions, ask yourself: Why am I paying someone whose interests may be at odds with my own? As the financial-services industry moves toward the fiduciary model, the trading-for-a-commission stock broker is increasingly an anachronism.)

This isn’t likely to be a big deal for the average individual investor. But, if your broker actively trades ETFs, then these transaction costs will have a very big impact on your total return.

But commissions aren’t the only thing that may take a bite out of your trading profits.

Another easily overlooked cost that diminishes an active trader’s total return is the bid/ask spread. This is the difference in price between what a buyer pays for a share of an ETF and what a seller gets when he or she sells that same share.

[See: 7 ETFs for a Solid Portfolio Defense.]

The difference between these two prices is how the market makers or specialists — the people who actually execute the trades — get paid. Remember, nobody on Wall Street works for free. Most investors pay scant attention to the inner workings of the market machine, and are probably not even aware that there is a real cost to each trade. Active traders, however, know they get nicked by the bid/ask spread every time they buy or sell an ETF. For them it can have a real economic impact.

But there is one other cost that is nearly completely invisible to all except the most-focused institutional investors.

All funds — ETFs, mutual funds and closed-end funds — are priced at net asset value. That’s the difference between assets and liabilities, divided by the number of shares outstanding. But its calculation is required to be made only once a day. According to the Securities Exchange Commission, net asset value is typically calculated “after the … exchanges close.”

So, investors (or traders) who buy (or sell) ETFs are likely paying (or receiving) a price that is something other than the actual value of the assets held by the fund.

Here’s how that works: An ETF’s price today isn’t likely to be the NAV that was calculated after yesterday’s market close. And, this not-so-easy-to-see cost of owning an ETF can be significant. In fact, according to professor Antti Petajisto of the NYU Stern School of Business, “prices of exchange-traded funds can deviate significantly from their net asset values.” Petajisto says the range can be as high as 2 percent in some cases. That is a pretty big variance!

For the individual long-term investor, exchange-traded funds are often an efficient way to get broad market exposure. That’s better than buying a bunch of single stocks and trying to create your own “bet.” Because of individual investors’ own biases and knowledge gaps, a homemade allocation is almost always less diversified than a broad portfolio of passively managed funds.

More active traders, those who like to make portfolio changes in response to the news, forecasts or market direction, are likely aware of hidden ETF costs and probably have them factored into their trading regimes.

[See: 9 of the Best High-Yield ETFs on the Market.]

Nevertheless, as with many things on Wall Street, it’s never a bad idea to remain vigilant. Caveat ETF emptor!

More from U.S. News

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With ETFs, There Is No Free Lunch originally appeared on usnews.com

Don’t Settle for Student Loans to Pay for Online Education

By WTOP Staff
Online college programs are becoming a more popular choice for prospective students, with one study finding that more than 6 million students enrolled in at least one online course in fall 2015. The popularity of these courses can be attributed in part to their flexibility with working adults' schedules, students' ability to progress more quickly through online programs and, oftentimes, cheaper tuition. [See 10 low-cost online bachelor's programs for out-of-state students.]Online degrees can be beneficial to many college students, but some studies have shown online learners complete their programs at lower rates than students at traditional brick-and-mortar campuses. Individuals with student loans but no degree comprise two-thirds of defaulted borrowers. Though these numbers are not encouraging, just like for traditional programs, there are ways to reduce how much you'll need to borrow for an online program to ensure you won't become one of these statistics. Don't just settle on borrowing student loans to cover the whole cost of your program and living expenses. Instead, start thinking about how to cut costs and cover your balance in different ways, such as the following. -- Grants and scholarships: Even though you are taking an online course, you can still apply and receive grants and scholarships. But your first step should be to complete the Free Application for Federal Student Aid, commonly referred to as the FAFSA, which will allow you to receive a Pell Grant if your expected family contribution is low enough. The EFC criteria and award amounts are adjusted annually, but the 2017-2018 academic year awards range from $606 to $5,920, which could significantly lower the amount you borrow annually. Your next step is to apply for scholarships. You can start by checking online scholarship search engines, such as the Salt Scholarship Search, College Board's BigFuture and Peterson's. But don't forget to take advantage of local organizations and your school's financial aid office. Both may offer scholarships that you can't find with a national scholarship search. [Review these 10 sites to kick off your scholarship search.]For instance, organizations like the Elks Club, Knights of Columbus or the Rotary Club typically offer scholarships annually to local students. Just because you're going to school online doesn't mean you're ineligible. Visit your local library for scholarship listings, and ask around town. You might be surprised how many local organizations offer scholarships. While these scholarships typically aren't large, every little bit counts. Each dollar you receive in a scholarship is a dollar you don't have to borrow and pay interest on. -- Work-study: Another option for online students may be work-study awards. Not all students enrolled in online programs are eligible, but students at some schools -- including, for example, SUNY Empire State College and Liberty University -- are. Work-study awards are not given upfront like scholarships and grants. In most cases, they are an offer to earn up to the awarded amount if you secure an eligible work-study job. While there is a misconception that all work-study jobs must be on campus, students can work for off-campus, nonprofit or public employers as long as the work is in the public's interest. You may be able to work for a for-profit employer if the job is relevant to your course of study. No matter who the outside employer is, it will need to have an established agreement with your college for you to receive work-study funds. Remember, to be eligible for federal financial aid, you must be enrolled and pursuing a degree or certificate. If you're not working toward a credential, Pell Grants and work-study won't be option, but you may still be able to take advantage of private scholarships -- just be sure to read the eligibility criteria carefully. [Explore what to know about financial aid in online programs.]-- Pay as you go: One of the great benefits to enrolling online is the flexible schedule, which can allow you to complete your college coursework around your responsibilities. But prospective students often overlook using their part- or full-time job earnings as an option for paying for college. Almost 80 percent of college students in 2015 worked at least part time while attending classes, according to the National Center for Education Statistics. By budgeting and thinking strategically about your college costs, you can likely reduce your dependence on student loans by paying a portion out of pocket. Many -- but not all -- online programs are less expensive than traditional programs and often have shorter payment periods. Six, eight or 10 weeks are common course durations. Because of the frequency of payments in an online setting, you may be well-placed to pay as you go and possibly avoid borrowing altogether. Attending college online and avoiding student loans may be challenging, but if you are willing to put in the effort, you can limit the amount you need to borrow. More from U.S. News Q&A: Understanding Student Loan Discharge Eligibility Student Loan Refinancing Isn't Right for All Borrowers
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