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Tuesday, July 6, 2010

When 'Cheap' ETFs Aren't Really Cheap

It seems like a no-brainer: All things being equal, you pick the exchange-traded fund with the cheapest fees. But, it turns out choosing an ETF based on the lowest annual expense could end up costing you more.

ETFs, of course, hold a basket of stocks or other investments and track an index. Many investors buy them assuming that all they’ll pay is the annual fee. But a growing number of pros are warning that some ETFs have hidden costs for trading them, which vary based on the ETF’s volume. In general, the more active the ETF, the cheaper it is to trade. “The bigger, the better,” says Jim Holtzman, a Pittsburgh-based adviser who has sought better ETF deals.

The iShares MSCI Emerging Markets Index fund (EEM: 37.75, +0.16, +0.42%) has $35 billion in assets and is nearly three times more expensive than its rival ETF, the $20.5 bil­lion Vanguard Emerging Markets ETF (VWO: 38.30, +0.08, +0.20%). But traders flock to the older iShares product because it has almost six times the average daily trading volume. “EEM is essentially where the fast money is,” says Bradley Kay, associate director of European ETF research at Morningstar. A Vanguard spokesperson says its ETFs’ trading costs are the same as or very close to those of its rivals. A big difference in trading volume can also be seen in two ETFs tracking the same index of inflation-protected bonds, iShares Barclays TIPS Bond (TIP: 105.82, -0.20, -0.18%) and SPDR Barclays Capital TIPS (IPE: 52.27, -0.12, -0.22%). The expense ratio of the iShares product is slightly higher than that of its competitor. But experts say iShares trades 18 times more often in part because each trade is cheaper.

While trading costs are important, Kay says investors who plan to buy and hold an ETF should go with the one that has the lowest expense ratio.

Disclosure I am long VWO, and EEM.

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