Several brokers are offering ETF (Exchange Traded Funds) trading for free. This is a significant change in strategy for ETF providers which may change the investment landscape. However, for this newsletter, we will concentrate on how it impacts you. Because trading costs can have a significant impact on long term investment performance, a free offer should merit serious consideration.

The first question to ask is: why is something being offered for free?

That is always a good first question and the answer is almost always, it’s not free. Like free to air television, someone is picking up the tab. In this case, the ETF providers are compensating the brokers (Fidelity and Schwab) to promote their products to retail investors.

Why are they doing this? Simple, they want to capture your stable retail assets.

The sponsors of ETFs are in the asset collection game not the investment performance game. The vast majority of ETFs are linked to an index or a commodity price. Their goal is to offer you exposure to a stated index or commodity price with the least amount of “tracking error” (the difference between the index price and the Net Asset Value of the ETF) possible.

ETFs are very popular with institutional investors, particularly with hedge funds and proprietary trading desks. In fact, one key feature of ETFs (low discounts/premia) is the ability of qualified institutional investors to deliver or receive the underlying basket of assets, creating or redeeming ETF shares at will. The fact that one can trade options, short and margin ETFs, like any other listed stock, makes them extremely attractive as the building blocks underneath many complex investment strategies.

But retail investors are still not as big a part of the pie as the large ETF providers would like. Why do they want you? Because having a stable base of shareholders provides a stable base of management fees to the ETF sponsor. Institutional investors provide deep liquidity and keep the ETF price in line but retail investors will provide the solid base of recurring income. The longer you hold an ETF, the longer the ETF provider gets to charge a management fee.

The second question is: Now you know why companies like iShares and Schwab are making this offer, should you take them up on it?

Here are three questions to help you decide if ETFs can be a part of your portfolio.

  1. Are you willing to manage the overall direction of your investment portfolio?
  2. Do you have enough money to participate?
    About $20,000 will allow you to buy enough round lots of 100 to get proper diversification.
  3. Do you have an online broker to provide low cost limit trades?
    $7-$10 a trade is the standard rate. But, because trading can be volatile, especially at the opening bell, you want to place limit orders to ensure a good execution near the NAV.

If you answer no to any of these three questions, you should probably stick with mutual funds for now. A no-load index fund will provide most of the benefits of an ETF and may be a better way to start exploring the benefits of low cost investment strategies.

If you answered yes to the three questions , we are building the resources you need. Check out our pages for Brokers and ETFs.

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