You Can Now Build Your Own ETF, Here’s How

Innovations in finance typically feed further innovation. The recent broad adoption of commission-free trading across most online brokerages makes it easier for investors to avoid Exchange Traded Funds (ETFs), and their fees, entirely. Here we’ll explain the pros and cons of doing that.

First off, let’s walk through the logic. Say you were paying $5 for a trade before the recent move to offer free trading by most online brokerages. If you wanted to own the S&P 500 then that’s 500 trades at $5 or a $2,500 cost. Given that some of the lowest-cost ETFs cost around 0.03% a year in expense ratio terms you have to be investing millions before it makes sense to create your own ETF. Now, with free trading that logic has changed. If buying 500 stocks costs $2,500 before, now it costs zero in commissions (though there are some hidden costs you should keep an eye on). That’s a major change.

So, should you buy your own basket of stocks rather than owning an ETF? It depends. The biggest factors are how many investments the ETF holds and how complex they are to trade, the ETF’s construction method and the fees it charges. Say the ETF you’re considering holds thousands of companies, it may be simplest for you to just own the ETF. Yes, you can buy a thousand different shares for free. However, your time isn’t free. The complexity of managing the process may not be worth it.Today In: Investing

The second aspect to think through is the ETF’s construction method. If the ETF is buying investments and holding them for the long-term at market weights, then a ‘set it and forget it’ approach of owning the investments directly may track the ETF fairly well. However, if the constituents of the ETF are changing on a monthly basis, then again the work involved in building your own ETF may not be worth it as you’ll likely need to trade frequently to keep up.

Another factor to consider is trading complexity. If the holdings in the ETF trade on a major, accessible market like the NYSE, then the ETF is easier to replicate. However, if it’s a set of foreign stocks that trade overseas then that’s trickier. Or if the ETF uses more sophisticated instruments such as futures contracts then that’s another challenge. Finally if the ETF is heavily into smallcap stocks where the costs of trading such as bid/ask spreads may add up then using an ETF may be an easier path. This is because the ETF may trade smallcaps more efficiently than you can.

Finally, it’s worth simply considering the fee that the ETF is charging and how much you’re investing. If you’re investing $1,000 in an ETF with a 0.03% fee then holding a basket of stocks yourself offers a saving of $0.30 a year. I’m going to guess that isn’t worth your time.

However, if you have $200,000 in an ETF that charges 0.75% then you could save $1,500 a year by owning shares directly. That’s more interesting. That said, if you’re paying 0.75% for an ETF it may pay to shop around for cheaper alternatives as a simpler solution than doing it yourself.

So take a look at how you’re using ETFs. If you’re investing $100,000s in each and they have relatively high fees and a handful of easily accessible stocks in them, it may be worth just owning those stocks directly.

Yet, if you’re investing a few thousand dollars and the fees are low, then owning stocks directly probably isn’t worth your time. Also, note that if you do own stocks directly, unless you’re very attentive, you’ll also likely see some drift against the index you track. This is because allocation weights can change as new stocks are added, or existing ones are removed. Finally owning stocks directly, if you’re doing it in a taxable account, may offer more opportunities for tax-loss harvesting. So yes, commission-free trading makes it easier to avoid using ETFs in certain circumstances, but that doesn’t mean that everyone should do it.

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