Exchange-traded funds (ETFs) have transformed investor access to markets through transparency, tax efficiency, and daily tradability. In recent years, active ETFs have grown in number and scope, offering professional management with the structural benefits of ETFs.
Yet many investors evaluate ETFs mainly by headline expense ratios and liquidity metrics like bid/ask spreads.
What investors often overlook is total cost of ownership (TCO)—a comprehensive measure capturing not just fees but also how premiums, discounts, creation/redemption mechanisms, and market-maker dynamics affect trading costs and outcomes. Ignoring these factors means they could pay more in hidden costs than they realize, undermining ETF investing’s value.
The Fee War
One of the significant wins for ETFs has been their lower management fees. Driven by passive and index funds, ETFs continue to push the lower bounds of inexpensive portfolio management. Today, you can build a virtually free portfolio. Even active ETFs have joined the action, undercutting mutual funds and other vehicles by several percentage points in expense ratios.
With several academic studies and industry white papers showing that lower-fee funds outperform expensive ones, the so-called “fee war” has become a phenomenon in portfolio management and construction.
As a result, many investors concentrate solely on the published fees when purchasing ETFs, particularly actively managed ones.
While this is an important starting point, it tells only part of the story. The total cost of ownership also includes implicit costs tied to how the ETF trades relative to its underlying assets—specifically premiums and discounts to net asset value (NAV)—and the bid/ask spread that investors pay when buying or selling shares. And it turns out that TCO matters more than just headline expenses.
Hidden Costs That Add Up
Every ETF has a NAV: the value of its underlying securities divided by the number of shares outstanding. In an ideal world, an ETF should trade at or near this NAV. In reality, however, an ETF’s market price can differ from its NAV—trading at a premium when demand pushes the price above the underlying value, or at a discount when supply pressure pushes it below.
Market makers try to keep share prices as close to NAV as possible. For a very liquid fund that tracks the S&P 500, this is easy. However, for a smaller active ETF, this becomes more difficult.
Premiums and discounts arise from several factors. Market sentiment, inflows and outflows, liquidity of the underlying securities, and efficiency of creation/redemption processes all affect how closely an ETF price tracks its NAV. During periods of stress or illiquidity—such as market sell-offs or low-volume trading—premiums and discounts can widen significantly, increasing transaction costs beyond expense ratios.
This can manifest in wide bid/ask spreads—the difference between the price buyers are willing to pay, and sellers are willing to accept. While highly liquid ETFs exhibit tight spreads, less liquid or niche ETFs incur wider spreads, increasing the cost of each trade. Because investors pay both when buying and selling, this cost can influence realized returns.
Then there is the more nuanced effect of creation/redemption mechanisms. ETFs can offload trading costs through in-kind custom basket creation/redemption processes when authorized participants deliver or receive baskets of securities rather than cash. This mechanism narrows bid/ask spreads and reduces transaction costs borne by investors because it allows market makers to use existing inventory instead of sourcing cash.
However, according to Morgan Stanley, some ETFs—including many active funds holding illiquid securities—use cash for creations and redemptions. This makes an ETF behave more like a mutual fund; the structural advantages of the ETF wrapper diminish. Market makers must account for cash handling costs, widening spreads and increasing the potential for higher premiums or discounts to NAV. Investors in these funds may unknowingly assume higher trading costs that are not reflected in the expense ratio. This also can reduce an ETF’s superior tax efficiency and possibly lead to capital gains distributions. 1
Another common measure of ETF cost is trading volume. High average daily volume typically corresponds with tighter bid/ask spreads and easier execution. While volume is a useful indicator of liquidity, it can be misleading if viewed in isolation.
Volume measures only secondary market activity, not the underlying ease of transferring shares to and from authorized participants via creation/redemption. An ETF might trade actively on the exchange, but if its underlying securities are illiquid or its primary market mechanism is inefficient, the true cost to arbitrage away premiums/discounts can still be high.
Putting TCO Into Practice: What Investors Should Do
According to Morgan Stanley, all of this underscores the limitations of evaluating ETF cost through a few simple metrics. Trading volume, expense ratios, and bid/ask spreads are all part of the picture—but not the full story. Investors seeking to minimize the total cost of ownership must integrate premium/discount behavior and creation/redemption efficiency into their analysis. And with that, investors should adopt a holistic approach to evaluating ETF cost.
- Compare Expense Ratios Across Vehicles, But Don’t Stop There – Management fees offer a necessary starting point but prove not to be determinative. Understand how structural factors make total costs diverge.
- Monitor Premiums and Discounts Over Time – Examine if an ETF trades near NAV consistently or swings wide in certain conditions. Historical patterns predict future cost behavior.
- Assess Liquidity in Both Secondary and Primary Markets – Look beyond exchange trading volume. Consider how easily authorized participants create and redeem in-kind shares, which maintains pricing efficiency.
- Understand Asset Class Dynamics – Some sectors, like fixed-income or international equities, tend to exhibit larger premiums/discounts due to underlying market structure. Investors in these areas should be particularly vigilant about total cost.
By incorporating these practices, investors avoid being “penny wise and pound foolish”—fixating on low fees while overlooking implicit costs from trading and holding.
Popular Active ETFs
These active ETFs, sorted by 1-year total returns from 5.1% to 17.4%, have expense ratios of 0.17% to 0.36%, AUM from $11 billion to $42 billion, and yields from 0.8% to 11.2%.
| Ticker | Name | AUM | 1Y Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| JEPQ | J.P. Morgan Nasdaq Equity Premium Income ETF | $32 billion | 17.4% | 11.2% | 0.35% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $40 billion | 17.2% | 0.8% | 0.17% | ETF | Yes |
| DFUV | Dimensional U.S. Marketwide Value ETF | $12.6 billion | 17.1% | 1.5% | 0.21% | ETF | Yes |
| DFAT | Dimensional U.S. Targeted Value ETF | $11.8 billion | 10.4% | 1.6% | 0.28% | ETF | Yes |
| JEPI | JPMorgan Equity Premium Income ETF | $41.5 billion | 9.5% | 7.7% | 0.35% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $19.4 billion | 9.2% | 1.4% | 0.25% | ETF | Yes |
| FBND | Fidelity Total Bond ETF | $22.9 billion | 7.8% | 4.4% | 0.36% | ETF | Yes |
| JPST | JPMorgan Ultra Short Income ETF | $35.3 billion | 5.4% | 4.2% | 0.18% | ETF | Yes |
| MINT | PIMCO Enhanced Short Maturity Active ETF | $14.5 billion | 5.1% | 4.4% | 0.36% | ETF | Yes |
ETFs democratize market access with low fees, transparency, and liquidity. Investors evaluating products solely on management costs, volume, and spreads risk underestimating true ownership costs. Morgan Stanley’s analysis underscores how premiums/discounts and creation/redemption mechanisms affect investor returns.
Bottom Line
In practice, understanding the total cost of ETF ownership means looking holistically at how an ETF trades relative to its NAV, how efficiently market makers can arbitrage price discrepancies, and how the structural mechanics of the fund influence investor outcomes over time. Investors who broaden their focus beyond headline fees are better positioned to evaluate ETF value accurately and make smarter investment decisions in both passive and active strategies.
1 Morgan Stanley (November 2025). Penny Wide, Pound Foolish? Calculate the Total Cost of ETFs
