The promise of commission-free ETFs has steered many index investors toward independent brokerages such as Questrade and Virtual Brokers. These deep discounters have a lot to offer, but before you sign on, make sure you understand the details of their pricing.

Orders at these brokerages may be subject to fees that originate with the exchanges and networks that match buyers and sellers. This includes the big boys such as the Toronto and New York Stock Exchanges, as well as a host of lesser-known electronic communication networks (ECNs) and alternative trading systems (ATSs). Though it’s not technically accurate, you’ll often hear all these costs lumped together as “ECN fees.”

ECN fees are applied on a per-share basis. They vary slightly depending on the brokerage and the specific exchange, but they’re always fractions of a cent. At Questrade, for example, the cost is $0.0035 on Canadian stocks and ETFs, while Virtual Brokers charges $0.0039.

It’s a very small cost—less than $2 on an order of 500 shares—but ECN fees are irritating because it’s hard to understand when and why they apply. So let’s dig a little deeper.

Staying liquid

ECN fees do not apply on every trade: they are only charged when a buy or sell order “removes liquidity.” What does that mean? An order that removes liquidity is one that is likely to be filled immediately. That includes all market orders, where the investor simply accepts the current price without specifying a minimum or maximum. It also includes marketable limit orders, which I described in my previous post. A marketable limit order specifies a price that is either above the ask (when buying) or below the bid (when selling). Like a market order, this type of limit order will usually be filled right away.

Now consider a limit order with a price that is lower than the ask (when buying) or higher than the bid (when selling): this is called a nonmarketable limit order, since it is not likely to be filled immediately. It will sit on the exchange’s order book waiting for someone to agree to the price being offered. Therefore, it “adds liquidity” to the market.

In most cases, whenever a trade is filled, one party adds liquidity and the other removes it. Only the latter will be charged ECN fees.

To help clarify this idea, let’s revisit the example I used in my previous post. Suppose three investors—Mark, Cheryl and Barney—want to buy 500 shares of the Vanguard Canadian Aggregate Bond (VAB). Their quote looks like this:

Our three investors place their buy orders as follows:

• Mark places a market order for 500 shares.
• Cheryl places a limit order for 500 shares at $25.56, two cents above the ask price.
• Barney places a limit order for 500 shares at $25.52, two cents below the ask price.

In this example, both Mark and Cheryl are likely to see their orders filled immediately, so they are removing liquidity. Both would incur ECN fees of $1.75 (that’s 500 shares × $0.0035). Barney’s order will probably not be filled right away, since it’s a nonmarketable limit order: because he is adding liquidity, he won’t incur ECN fees.

Now that’s odd

There is another way you can incur ECN fees, even if you use a nonmarketable limit order: by placing orders that are not multiples of 100 shares.

In trader jargon, blocks of 100 shares are called board lots, while blocks of fewer than 100 shares are called odd lots. If you place an order for 420 shares, for example, it’s called a mixed lot, consisting of four board lots plus one odd lot of 20.

According to Questrade’s forums, an odd lot can remove liquidity even if your limit price is above the bid or below the ask. Moreover, a mixed lot may get broken into two separate orders, with the board lots and odd lot filled separately. If this happens, ECN fees may apply to the odd lot, though not the entire order.

This isn’t a big deal if you’re buying 1,005 shares. But many ETF investors will make frequent small trades, since they’re not paying any commissions. And if you’re routinely buying 70 or 80 shares, then all your orders will be odd lots and they may incur ECN fees no matter where you set your limit price.

Penny wise, pound foolish

So what’s the advice for investors using brokerages that charge ECN fees? This is a popular question on web forums, and the answer usually goes like this: “Make sure you always use limit orders that add liquidity, and only trade in board lots.”

But while that will help you avoid ECN fees, I think it’s bad advice. First, it’s not realistic to always trade in board lots, which can easily be multiples of $2,000 to $3,000. More important, using nonmarketable limit orders is poor practice that can easily lead to throwing away dollars to save pennies.

Let’s return to our example, where Barney uses a lowball order to sidestep ECN fees. Imagine his original buy order at $25.52 goes unfilled, and within an hour bond prices start to tick up. Soon the ask price of VAB is $25.56, and then $25.58. When the markets close at 4 pm, Barney’s order expires. The next day, with more turmoil in the stock market, bond prices are higher again and the ETF is trading at $25.60 by mid-morning. Now Barney places another nonmarketable limit order to buy 500 shares at $25.58, and this time he gets lucky: the price falls briefly, his order eventually gets filled, and he saves $1.75 in ECN fees.

But look what happened: Barney’s cleverness means he wound up paying $25.58 for a fund he could have bought the day before for $25.54 if he had simply placed a marketable limit order. That means he paid an opportunity cost of four cents per share, or $20, to save that $1.75.

The lesson here should be clear: if your brokerage offers commission-free ETFs, just accept the ECN fees as a reasonable trade-off. Use marketable limit orders for all your trades, even if it costs you a couple of bucks. It makes no sense to risk seeing your order go unfilled to save a fraction of a penny per share. Costs are always important in investing, but don’t forget that opportunity costs can be much higher than commissions and fees.