Fees on mutual funds and exchange-traded funds have been dropping so low that investors can now get the access and capabilities once enjoyed only by large institutions like pension funds at minimal cost.
That’s a great benefit, though the proliferation of low-cost funds can also increase risks for people who may not know how to handle them, strategists say.
Exchange-traded funds are priced all day on stock exchanges, unlike traditional mutual funds, which are priced only once daily, after the exchanges close. E.T.F.s also offer some tax advantages compared with mutual funds, said Larry Stein, a certified financial planner who manages more than $30 million at his Disciplined Investment Management firm in Deerfield, Ill.
“All of my investments are in very basic traditional E.T.F.s,” Mr. Stein said. “It gives me the greatest diversification at the lowest possible cost.”
A fee price war is underway. In a February filing, for example, the Vanguard Group said it was reducing fees on 10 funds with combined assets of $176 billion. Then SoFi, an online lender, said it planned to offer zero-fee E.T.F.s, while Charles Schwab (SCHW) and Fidelity increased the numbers of E.T.F.s. that could be traded without commissions. State Street Global Advisors, Defiance, BlackRock (BLK) and DWS also announced that they were starting new low-fee funds, while JPMorgan Chase (JPM) cut the fees on one of its United States stock funds to 0.02 percent.
By the end of 2018, XTF, a fund analysis firm, found that nearly three-quarters of all assets in E.T.F.s were held in funds with expense ratios of less than 0.2 percent — just $2 for every $1,000 invested.
Low-cost index mutual funds have been gaining popularity, too.
In September, Fidelity introduced two index mutual funds with zero expense ratios, even lower than Vanguard’s cheapest index fund, the 500 Index Fund Admiral Shares (VFIAX), which has a ratio of 0.04 percent. The Fidelity funds — the Zero Total Market Index Fund (FZROX) and Zero International Index Fund (FZILX) — took in $1 billion in their first month. In March, BlackRock announced that it would cut fees on its iShares S&P 500 Index Fund (BSPIX) to $1.25 for every $10,000 invested from $4, making it BlackRock’s cheapest fund.
The failure of most active investment managers to match — much less beat — major indexes such as the Standard & Poor’s 500 (.SPX) or the Dow Jones Industrial Index (.DJI) has created a strong argument for cheap index funds that simply mimic those benchmarks.
“More investors are appreciating the virtues of index investing, and more investors are appreciating the value of low cost — the less you pay for your investments, the more you have in your account,” said Rich Powers, who heads E.T.F. management at Vanguard.
With just a few E.T.F.s, an investor can build a broadly diversified portfolio in domestic and foreign stocks and bonds.
The Bogleheads, a group of admirers of John C. Bogle — the founder of the Vanguard Group and the godfather of low-cost investing — often recommend a simple, three-fund portfolio that tracks the total United States stock market, international stock markets and the domestic investment-grade bond market. Through 2018, such a portfolio, with 60 percent allocated to stocks and 40 percent to bonds, returned 8.2 percent, annualized over 10 years and 5.57 percent over 20 years.
Warren E. Buffett has recommended an even simpler approach for most investors: a two-fund strategy, split between short-term government bonds and a low-cost Standard & Poor’s 500 index fund. He said he thinks the “long-term results from this policy will be superior to those attained by most investors.”
The explosion of cheap funds has created some dangerous temptations for investors, however. For one thing, the ability to buy and sell E.T.F.s just like stocks can encourage too much daily trading, with associated expenses that eat into returns. Some funds are narrow in focus and not suitable for all portfolios. Simply because a fund is cheap does not mean that it’s a wise investment.
Investors should look beyond low expense ratios to the spread in bid and ask prices offered by buyers and sellers. Smaller or more thinly traded E.T.F.s can bear wider spreads that defeat low fees, while bigger, more popular funds tracking common indexes can offer lower total costs.
“Broadly diversified E.T.F.s usually trade in a tight spread,” said Mr. Powers of Vanguard. “We always encourage investors to look at the spread, especially when they’re comparing these very low-cost funds.”
Another caveat is that a portfolio of basic E.T.F.s or index mutual funds will rise and fall with the broad market. That’s great when markets are rising. But investors who’ve used only index funds during this decade-long bull market could be in for a surprise when a real bear market emerges.
If you are likely to need money soon to live on, for example, you will want to make sure you have managed the risk of your portfolio carefully, Mr. Stein of Disciplined Investment management said.
“But for young people who don’t need to manage risk, E.T.F.s are an incredible thing,” he added. If all goes as expected and you are truly invested for the long term, he said, there is a good chance that you can “close your eyes and look at it 30 years later and you’re going to be very happy.”
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