#71 Are «free ETF savings plans» really free?

When online brokers, both domestic and international, advertise «free» savings plans, skepticism is warranted. While certain providers do indeed waive commissions for the purchase of ETF shares, meaning no direct trading fees are incurred, simply avoiding so-called brokerage fees does not necessarily mean you’re getting a good deal when buying the ETF.

The trick with the trading spread

The reason for this lies in how stock market trading works. As long as a stock exchange is open, there are virtually always market participants willing to buy or sell highly liquid securities, such as large ETFs, at a specific price. With smaller ETFs, however, there may be temporary lapses in demand. To ensure liquidity nonetheless, so-called «market makers» are brought in. These market makers hold a small inventory of securities on their own account and constantly provide a bid and an ask price within the exchange system. Since the market maker expects to be compensated for the risk they assume, these two prices differ. Buyers pay a slightly higher price than sellers. This price difference is called the trading spread or «bid/ask spread». This is where many savings plan providers come in: Depending on the model, they forward buy orders to a less heavily traded exchange where they have an agreement with a market maker. Since the market maker faces little competition there, they can set the prices far apart – the bid-ask spread widens. They then share the resulting profit with the savings plan provider. For investors, this means they indirectly pay more for their ETF shares than they actually should. When they later sell, the same thing happens: the proceeds are lower than hoped for. If a foreign currency is also involved, an additional hidden spread arises in the exchange rate.

Hidden fees in management expenses

There are other sources of revenue that can erode your returns. While ETFs are known for their low management fees, there are significant differences here as well. Providers of so-called «free» savings plans often have a financial incentive to eventually persuade their customers to purchase slightly more expensive products. This is often due to agreements with the respective «ETF provider» (the issuer), who pays the broker sales commissions, so-called «retros» or «kickbacks», for placing the fund. These commissions are naturally more generous for an ETF with higher management fees. Ultimately, you end up paying for the supposed «fee-free» service indirectly through the kickbacks paid by the market maker and the ETF provider. In the financial world, «free» is rarely truly free.

Conclusion

In principle, regular, long-term investing in ETFs is an extremely sensible approach – both for your own wealth and for the economy. However, you shouldn’t be blinded by the illusion of a «free» package. How do you invest in ETFs? Send me an e-mail.