- Even small differences in expense ratios can have an impact on investor returns.
- Consider any transaction costs and commissions.
- The bid-ask spread varies for exchange-traded funds (ETFs).
- The difference between ETF and index performance, known as tracking difference, may impact returns.
From 2007 through 2017, domestic equity index mutual funds and exchange-traded funds (ETFs) received more than $1.6 trillion in cumulative net new cash and reinvested dividends.
A big part of the allure of passive investments is their low cost relative to most actively managed mutual funds and ETFs. Mutual funds and ETFs come in many flavors. With active funds and ETFs, a manager attempts to deliver performance that outpaces a chosen index, often referred to as a benchmark. Passive ETFs and mutual funds, on the other hand, try to match market performance based on a benchmark (for example, the S&P 500). Passive investments may not offer the potential of outperformance, but they are typically offered at lower costs compared to active funds managed against a common or similar index or benchmark.
Once you limit the potential for outperformance, issues of costs become more important when selecting investment options. When it comes to cost, most investors focus on the expense ratio—the annual percentage of assets that the fund charges. That is a key expense, but it's not the only one, as costs can vary dramatically among seemingly similar passive index funds and ETFs.
Here are 5 key costs to consider when checking out passive funds.
Cost of doing business: Expense ratios
Perhaps the most closely watched fund cost is the expense ratio. Each year, mutual funds and ETFs charge investors a fee to cover services such as investment management, recordkeeping, compliance, and shareholder services. In general, the total cost is much lower for passive strategies than for active ones, but that is not always the case, and even among passive products there is a significant range of costs.
In fact, among the large-cap-blend index funds that track indexes such as the S&P 500 and are available to Fidelity's brokerage customers without transaction fees, expense ratios range from as little as 0.0%, to more than 1.5%. Likewise, passively managed domestic large-cap, core-blend cap-weighted equity ETFs on Fidelity's platform have expense ratios that range from just 0.03% to 0.60%.
Tip: When comparing products where performance is likely to be similar, expenses matter a great deal.
Ticket to ride: Transaction fees
When you make an investment in an index mutual fund, there may be an up-front charge to buy shares—called a transaction fee. As of August 15, in the Fidelity mutual fund research center there were about 410 index mutual funds, and more than 225 charged transaction fees. With an ETF, investors often have to pay a brokerage commission. Typically these are relatively small costs, but there are times when they can add up.
One such time is if you make regular contributions into a chosen mutual fund. Each additional investment could come with a purchase fee. Say one fund is available free of transaction costs while another costs $75. If you are making monthly purchases, a fee of this kind could add up to $900 a year and quickly dwarf minor differences in expense ratios.
Trading commissions for ETFs are typically small. But for investors who make a lot of ETF purchases and sales, they can become substantial.
Tip: See if your broker offers index funds without transaction fees or ETFs that trade commission-free, and weigh the benefits of that against other characteristics of the investment options.
Mind the gap: Spreads
When it comes to mutual funds, anyone buying or selling on a given day gets the same price, the net asset value (NAV), which is typically set at the close of the market. But when it comes to ETFs, the shares trade on the secondary market, which means the price is set by buyers and sellers. The difference between the price at which people are willing to buy and sell is called the bid-ask spread, and for some ETFs it can amount to a significant cost.
Let's say the bid for an ETF is $50.00 and the ask is $50.50. If you bought the ETF, then wanted to turn around and immediately sell it, you would lose 50 cents a share plus commissions. For investors who trade large volumes of shares and regularly buy and sell ETFs, those differences can add up.
Of course, you can't escape bid-ask spreads, but these amounts vary widely among ETFs. Using Fidelity's ETF screener, you can research the average monthly bid-ask ratio. For example, if you look at the 26 domestic energy ETFs (excluding leveraged and inverse products), the average monthly bid-ask spread ratio ranges from 0.01% to 1.88%.*
Tip: Typically, ETFs with the highest trading volume will have the smallest spreads. So if multiple ETFs exist that meet your goals, weigh liquidity as part of your selection process.
Factor in performance: Tracking difference
Passive strategies are designed to track the performance of an index. But while that sounds simple, it's not that easy. To some extent, all passive products will differ from the performance of an index and this difference between ETF performance and index performance is known as "tracking difference."
Tracking difference isn't a cost that a fund company charges you, but it can detract from your return. So before you invest, take a look at the performance history.
Tip: Compare the performance of any index fund or ETF with that of competing products and the underlying index. All things being equal, a smaller tracking difference is better.
Consider what you keep: Taxes
When a fund sells the stocks in its portfolio to realize profits, reinvest, or raise cash for exiting investors, it can create taxable capital gains, which the fund usually has to distribute to shareholders. Any taxes paid on these capital gains reduce an investor's after-tax return. All funds are likely to generate capital gains eventually, but there are differences in the way index funds and ETFs are run that may make them more or less likely to generate taxes for investors. (Learn more about fund and ETF tax differences.) And even within passive index funds and ETFs, how the particular fund or ETF replicates an index, tax lot management, turnover, and rebalancing can all have an impact on capital gains distributions.
Tip: If you are investing in a 401(k) or IRA, taxes on fund distributions aren't an important consideration. Otherwise, look back at historic capital gains distributions and fund turnover to get a sense of the tax efficiency of the investment options. Fidelity's ETF screener lets you measure the tax cost ratio to get a sense of historic tax impact.