Is There a Free Lunch in Commission Free ETFs?

How Holding and Transaction Costs Can Affect the Cost Calculus of Commission-Free ETFs

2016 Volume 19 Issue 2

Competition amongst discount brokers for investment dollars continues, and in recent years has reached a point where many offer commission-free exchange-traded funds (ETFs). Since minimizing costs from increased market efficiency is always of interest, commission-free ETFs may seem an obvious choice over other ETFs that carry a nominal commission. Unfortunately, other costs can play a role that can marginalize the perceived advantage of the commission-free ETFs, and in some cases, warrant the selection of an ETF that carries a commission. This study investigates how holding and transaction costs can affect the cost calculus of commission-free ETFs. The results provide a clear recommendation on how to minimize costs using commission free ETFs.[1]


financial-trading-shutterstock_148356704-200x150The growth of ETFs continues, as the benefits for individual investors become more widely recognized. Discount brokers have taken notice, and chosen to begin offering commission-free ETFs since 2010, in hopes of retaining existing investors and attracting new ones.[2] The major players currently offering commission-free ETFs are Ameritrade, Fidelity, Schwab, and Vanguard.[3] This outcome is not surprising, based on Schwab’s Investor Study (2012) that cited “cost as the top factor investors consider when selecting ETFs, with nearly 40 percent of respondents saying the ability to trade without fees was either most important or very important.”

But what is an ETF, and why does it appeal to individual investors? Exchange-traded funds (ETFs) are securities that trade throughout the day on an exchange like common stock. One key difference, however, is that they are designed to track an underlying index like the S&P 500, so they also behave like an index mutual fund. Individual investors often pick ETFs due to their low expense ratios, low tax liabilities, direct access to particular market segments, and greater flexibility in timing transactions.

To differentiate themselves, some discount brokers highlight the number of commission free ETFs they offer, presumably to improve diversification or returns.[4] [5] It is unclear whether some costs have been obscured or lost. Perhaps simply having more investment options may not lead to better investment outcomes? Constable notes that too many choices in 401(k) plans led to poorer returns.[6]

This article examines cost minimization in light of the changing marketplace of commission-free ETFs. Specifically, we wish to answer two questions:

  1. If an individual investor is willing to move their account to one of the four discount brokers examined here, which broker would minimize their costs?
  2. If an individual investor is not willing to move their account, but wishes to trade the lowest cost ETFs at their existing broker for a fee, what premium must they pay in the form of commissions to stay at their current broker?

We selected these questions to highlight the importance of total cost, of which commission is one of three costs that we discuss in the next section. By including the aspect of willingness versus unwillingness to move an account, we recognize that there may be reasons not related to cost that keep investors at their existing broker. These reasons could include, but are not limited to, personal relationships, time needed to transfer funds, and ease of use of the broker’s web platform.

This challenge has been publicized for several years, such as by Jaffe,[7] but existing academic literature on the topic is sparse. Due to the rapidly growing landscape of ETFs and continued competition amongst discount brokers, we feel these are important questions to address.

ETF Costs for Individual Investors

We identified three costs that are incurred by an individual investing in ETFs. They are:

  1. Expense ratios
  2. Trading commissions
  3. Bid-ask spreads

Expense ratios are an ongoing cost, quoted on an annualized basis, and provide revenue for the fund provider to manage the fund and generate a profit. Since many ETFs are simply trying to track an underlying index, ETF expense ratios are often touted as one of the benefits over actively managed mutual funds because many ETFs do not carry the cost burden of active management. Trading commissions are another cost, and are typically a flat rate associated with buying and selling a specific ETF. While typically less than $10, a trade at many discount brokers can mean incurring a cost for each trade and can significantly reduce returns, especially for smaller portfolios with higher turnover rates. As cited in Barber and Odean (2000), portfolio returns over a 5-year period in the 1990s were reduced from 17.4 percent per year to 11.4 percent per year by increasing portfolio turnover from buy-and-hold to buying and selling the portfolio 2.5 times.[8]

The last cost is the bid-ask spread. It is a measure of liquidity, and can have significant variability based on market conditions. This cost occurs whenever an individual makes a trade, due to the difference in what the market currently is asking to sell the ETF, versus what a buyer is interested in paying for it. While time of day is known to affect the bid-ask spread (see McInish and Wood[9] and Sibears[10]), trading volume is known to play a key role, with higher volumes often leading to lower spreads.[11] Thus, for an individual investor interested in minimizing cost, market orders should not be placed at either the beginning or end of the day,[12] and higher volume ETFs should be selected.

To simplify the forthcoming analysis, neither short- nor long-term capital gains taxes are considered as costs. Thus, we have assumed the investments are held in a tax-deferred or tax-exempt account. We also assume that all trades are executed as market orders, which were selected to ensure that the buy-and-hold and active strategies considered in the following sections could be executed successfully. However, it may be possible to mitigate some of the trading costs by using limit orders. Unfortunately, investors using limit orders may experience execution risk (e.g. not getting a trade executed within a preferable time frame). Consequently, order execution may occur later than preferred, and at either higher purchase price or lower selling price than could be obtained with a market order. Lastly, we assume there is no currency exchange differential, so that the individual investor is expected to use U.S. dollars as their primary currency.

Data on Four Discount Brokers

We drew information from two primary sources. The first source of information was each brokerage firm’s website, where expense ratios were found to estimate the annual cost of holding an ETF.[13] We found average bid-ask spread values and volume data from the website, using an Excel Visual Basic for Applications (VBA) script that automatically downloaded the data. Tables 1a and 1b show the expense ratios and other attributes for each of the four brokerage firms for fixed income and equity-based ETFs, respectively.




In Tables 1a and 1b, we restricted our focus on ETFs that invest in the U.S., recognizing that increased globalization has led U.S. firms abroad, so that correlation of returns between domestic and international investments continues to increase. This approach captured over 60 percent of commission-free ETFs offered by Ameritrade, Fidelity, Schwab and nearly 80 percent of those offered by Vanguard. We excluded funds that held investments outside the U.S., such as international equity funds, global bond funds, foreign currencies, and commodities. We also chose to exclude funds that were pure commodity plays.

Tables 1a and 1b show that, for investors looking for the largest selection of commission-free ETFs, Schwab is the discount broker of choice. However, the increased choice that Schwab account holders enjoy comes at a cost, where their average expense ratio and bid-ask spread is the highest. This trade-off between choice and expense ratios also occurs for Vanguard account holders, who if they are willing to accept the fewest investment options, can enjoy the lowest expense ratios, although not always the lowest average bid-ask spreads. Vanguard carries a slightly larger average bid-ask spread across its fixed income funds than Ameritrade. In the following sections, we will examine the costs imposed on investors holding accounts employing a naïve allocation, where investments are spread evenly across the commission-free ETF options available. The benefits of a naïve allocation strategy are quantified nicely by DeMiguel et al.[14]

Buy-and-Hold investors

We first consider a buy and hold investor, who purchases equal dollar amounts of each ETF offered by a discount broker, then sells these investments many years later. Eq. (1) was used to estimate the total cost for the ith discount broker, where the “bar” over expense ratio and bid-ask spread denote average values.

Equation 1.


The first term in Eq. (1) represents the cumulative cost of the expense ratio over the holding period. The second term covers the cost of the market order executed at the beginning and end of the holding period. The last term estimates the effect of commission (if any) of buying nv bond or stock ETFs. In the results that follow, nv will be either 14 for fixed income Vanguard ETFs, or 28 for Vanguard stock ETFs, because in the absence of commissions, expense ratios are the dominant total cost for buy-and-hold investors. As will be shown in Table 2a and 2b, the lowest total cost over all holding periods, which is used to answer the 2nd question from the introduction, are found by buying Vanguard ETFs and paying a commission.   Table 2a displays the results for the fixed income ETFs from each of the four discount brokers.



Reviewing Table 2a, it is clear that in the absence of commissions, a Vanguard account holder would have the smallest cost over all holding periods. This answers the first question posed in the introduction. But, what if an investor is not interested in moving their account from their current discount broker, and instead is willing to pay a $10/trade commission to buy and hold the 14 Vanguard fixed-income ETFs? The right three columns in Table 2a answer this question. Investors willing to pay a $10 commission to buy and hold the Vanguard fixed income ETFs would, in most cases, still maintain a lower cost than if they moved their account to one of the three other brokers that offer commission-free trades. The only exception is for the shortest holding period (5 years) and smallest account size ($50,000). In this case, the investor pays a small cost premium relative to an Ameritrade account holder. However, in all cases, paying commissions while investing in Vanguard fixed income ETFs is still cheaper than investing in commission-free fixed income ETFs at Fidelity or Schwab.


The total cost for equity investors appears in Table 2b, which has similar findings. Once again, if an investor is willing to move their account to one of the four discount brokers, their total cost would be minimized if they move their account to Vanguard, and invest only in commission-free Vanguard ETFs. However, a slightly different story emerges if the investor does not wish to switch their discount broker, as there are twice as many Vanguard equity-based ETFs as fixed-income ETFs. Thus, to hold a naive allocation of Vanguard equity-based ETFs, commission costs double. This causes the two smaller portfolios with 5-year holding periods, and the smallest portfolio with a 10-year holding period to no longer minimize total cost when compared to holding commission-free equity-based ETFs at Ameritrade and Fidelity. However, if an investor maintains a 20-year holding period, the lower expense ratios associated with the Vanguard equity-based ETFs more than offset the $10 commissions, when compared to the commission-free equity-based ETFs from Ameritrade, Fidelity and Schwab.

Active Investors

Many investors prefer to trade in their accounts more frequently. In the results that follow, we show how investment returns are reduced over a single year, rather than the 5- to 20-year holding periods in the previous section. While most discount brokers do not allow for zero-commission ETF trades to occur more often than approximately once per month, there is still ample opportunity to trade without commissions throughout any given year. To better understand the cost of more frequent trading, we developed Eq.(2) to estimate the cost of trading over a 1-year holding period with a turnover rate .

Equation 2.


In Eq. (2), we assume a turnover rate includes changes (if any) to the portfolio throughout the year, as well as selling it at the end of the year. For example, an investor with a turnover rate of T = 1 does not conduct any trades during the year, except to sell the portfolio at the end of the year, while one with a rate of T = 11 completely turns over the portfolio every month. Eq. (2) also assumes that while the portfolio weights may change throughout the year, the average portfolio holdings throughout the year incur the costs of the average expense ratio and bid-ask spreads determined in Tables 1a and 1b. That is, the turnover creates portfolio weights that may vary over the year, but over time averages out to the naïve portfolio allocation. The results for various turnover rates appear in Table 3a for fixed income funds, and Table 3b for equity-based ETFs.


As the left columns from Table 3a indicate, an investor willing to move their account should make their decision based upon their expected turnover rate. For turnover rates less than or equal to 3, an investor can minimize their total costs by trading Vanguard funds in a Vanguard account. However, the larger average bid-ask spread for the Vanguard fixed income funds no longer minimize costs for more frequent traders. Instead, when the turnover rate is 4 or more, an investor can have lower costs with an Ameritrade account and their commission-free fixed income ETFs.

The right columns in Table 3a show the significantly increased costs when commissions are included, where the first two rows correspond to investing in the lowest cost funds Vanguard fixed income ETFs, while the second two rows correspond to investing in the lowest cost Ameritrade fixed income ETFs, as highlighted in the previous paragraph. For investors with $50,000 accounts, not moving to a broker with commission free ETFs always incurs a cost premium. The results for the investors with mid-size accounts ($100,000) are more mixed, where the cost premium disappears with Schwab, but not the other brokers. For investors with accounts valued at $500,000, their cost premium disappears when compared to Schwab for all turnover rates, and Fidelity at lower turnover rates.


Table 3b shows results for equity-based ETFs, where regardless of the turnover rate, investors willing to switch their account to Vanguard for their commission-free equity-based Vanguard funds will incur the lowest total cost. For investors not willing to switch their account, the cost premiums they pay are similar to before. For account holders with $50,000 willing to pay $10 per trade to own Vanguard ETFs, these investors will always pay a cost premium versus moving their account to any of the other four discount brokers. Accounts with $100,000 would also pay a premium versus account holders at Ameritrade, Fidelity, and Vanguard, but not Schwab at a turnover rate of one. Lastly for accounts with $500,000 or more, the cost premium persists versus account holders at Ameritrade, Fidelity and Vanguard, but never at Schwab.


This study evaluated the total costs associated with commission-free ETFs offered by four major discount brokerages, and for individual investors seeking either a buy-and-hold or a more active approach. We identified that, in most but not all cases, investors willing to move their accounts could minimize their total costs by selecting a Vanguard account. The exception to this finding was for investors who expect to have a high turnover rate in their account, where an Ameritrade account was preferred. We also discovered that, for investors not willing to move their accounts, there may or may not be a cost premium, which is largely dependent on their account size and trading frequency. For lower turnover rates and larger account sizes, there was a minimal cost premium to paying a $10 commission for each trade.

DISCLAIMER: The exchange traded funds analyzed in this article were chosen from those publicly available. Investment advice is neither implied, nor suggested. Furthermore, the findings of this study do not represent an endorsement by the authors, Pepperdine University or Northwestern University.


[1] Support for this work was made possible through the Julian Virtue Professorship provided by Pepperdine University’s Graziadio School of Business and Management. The authors also wish to thank Darrol Stanley and Levan Efremidze for providing excellent suggestions that improved an earlier version of this manuscript.

[2] Maxey, Daisy, “Vanguard Joins Cuts of ETF-Trading Fees,” The Wall Street Journal, May 5, 2010.


[4] A few lesser known brokerages also offer commission-free stock trades, such as Robinhood and Loyal3, provided investors are willing to trade exclusively on a mobile device or have shares purchased as part of a larger batch at the end of the trading day.

[5] Arshanapalli, Bala G., and Nelson, William B., “Yes Virginia Diversification Is Still a Free Lunch,” Journal of Wealth Management, (2010): 34-40.

[6] Constable, Simon, “Are Too Many Choices Costing 401(k) Holders?” Wall Street Journal, February 7, 2016.

[7] Jaffe, Chuck, “Hidden Costs of Free ETF Trades at Schwab,” Marketwatch, February 11, 2013.

[8] Barber, Brad M., and Odean, Terrance, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 60 no. 2 (2000):773-806.

[9] McInish, Thomas H., and Wood, Robert A., “An Analysis of Intraday Patterns in Bid/Ask Spreads for NYSE Stocks,” Journal of Finance, (1992):753-764.

[10] Sibears, Justin, “ETF Bid/ask spread: Timing is Everything.” Accessed February 15, 2015,




[14] DeMiguel, V., Garlappi, L., and Uppal, R., “Optimal Versus Naïve Diversification: How Inefficient Is the 1/n Portfolio Strategy?” Review of Financial Studies 22 (2009):1915–1953.

About the Author(s)

James A. DiLellio, PhD, MBA, is an Associate Professor of Decision Sciences in the Graziadio School of Business and management at Pepperdine University. He holds a PhD in Applied Mathematics from Northwestern University, and a MBA from Pepperdine University. His current research interests are primarily in the area of nonlinear optimization, simulation, and Kalman filtering techniques for modeling investment problems. The application of this research covers portfolio management, retirement planning, commodity price modeling, and the analysis of investment strategies. He has published papers in Energy Economics, Journal of Economics and Finance, Journal of Investing, and Financial Services Review.

Philip M. Goldfeder, PhD, is a Faculty Consultant in the Masters of Science in Predictive Analytics program at Northwestern University, where he also earned a PhD in Applied Mathematics. His prior work was as a management consultant with Booz & Company (formerly Booz Allen and Hamilton), specializing in mergers and acquisitions. He has been published in Journal of Phys. Chemistry B, Mathematical Problems in Engineering, and Journal of Engineering Mathematics, as well as several chapters in the Macmillan Science Library.

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