Expense ratios

One of the basic tenets of investing is "Don't pay more in fees than necessary." You can't control whether you'll make a profit or loss on any investment, but you can control what you pay to acquire and hold the investment.

Fees and profits

Fees are fairly consistent, in the sense that they consistently eat into your profits (also known as your return on investment, or ROI). This is one area where investors should focus a lot of their attention. But the sad fact is that many investors never consider fees when evaluating an investment.

Lower fees should be one of your top priorities in any investment product. Smaller fees equal more money in your pocket. Sometimes you need to pay more for a higher level of service, but not in index-based products.

In a mutual fund's prospectus, after the load disclosure is a section called "Annual Fund Operating Expenses." This is better known as the expense ratio. It's the percentage of assets paid to run the fund. Many costs are included in the expense ratio, but typically only 3 are broken out: the management fee, the 12b-1 distribution fee, and other expenses. And, it's not that easy to find out what fees are contained in the "other expenses" category. The size of the expense ratio determines how much money the investor ends up with.

Why ETFs may have lower fees

ETFs avoid many of these fees because the fund usually doesn't buy or sell the stock held in its portfolio. This may sound strange: The fund holds stock but doesn't buy stock. That's the secret. By not buying stock, the ETF avoids all kinds of charges. It puts the burden on the people or firms causing the trades. It does this through a unique device called the creation unit.

The fund manager provides a list of securities each day that it will accept in exchange for newly issued shares of the ETF. For index funds, these shares are typically identical in number and weights to what the individual names constitute of the index the fund is seeking to track. For ETFs, the portfolio manager is likely setting creation baskets in a way that deviates from the benchmark to get more exposure to names they currently favor and less (or no) exposure to names they would like to underweight.

Redemptions work in a similar fashion. If an Authorized Participant (AP) wants to redeem shares (sellers want out of the fund) the ETF manager publishes a list of securities (and weights) the AP can expect to get back if they redeem shares of the ETF.

There are a few other factors that help reduce expense ratios for ETFs, like no 12b-1 fees; for index ETFs, due to their innate structure, the fund portfolio remains static.

By creating a way for the ETF to hold stocks without buying stocks, it doesn't have to pay brokerage commissions or any other transaction costs—that's a major area of cost savings outside of the expense ratio. The buying and selling costs, the brokerage costs, and the transfer agency costs associated with buying the portfolio stocks and transferring them to the ETF are all borne by the AP. The AP even pays the fund's custodian a fee to receive the shares into the fund and another to deliver the shares out of the fund. That's because the AP, not the fund, is responsible for gathering the stocks for the creation unit and for taking them back upon redemption.

As always, there are exceptions. Non-equity ETFs composed of alternative assets such as commodities are composed differently and have different holding structures and different associated costs.

Fees are important to evaluate as part of any investment purchase you make. Lower fees could mean more money in your pocket.

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Article copyright 2011-2024 by Lawrence Carrel. Reprinted and adapted from ETFs for the Long Run: What They Are, How They Work, and Simple Strategies for Successful Long-Term Investing with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint. The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses.