How to shop smart for index funds and ETFs

Here are 5 key costs to consider when checking out index funds and ETFs.

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Key takeaways

  • Even small differences in costs can have an impact on returns.
  • Consider transaction costs and commissions.
  • Investors should understand how the difference between the buying and selling prices of exchange-traded funds (ETFs) affects returns.

Mutual funds and ETFs come in a variety of flavors. Many investors have developed a taste for index mutual funds and ETFs, which have become a staple of many portfolios.

Part of the appeal of so-called passive investments is their low cost compared to most actively managed mutual funds and ETFs. 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 the performance of a benchmark. Benchmarks may include familiar indexes such as the S&P 500, as well as custom benchmarks created by a fund's managers. Passive investments may not offer the potential to outperform an index, but they typically offer lower costs than active funds managed against a similar index or benchmark. Since 2019, Fidelity has offered investors 4 index mutual funds that have zero expense ratios and no required minimum investment amount. 

If a fund or ETF doesn't offer the potential to outperform an index or benchmark, cost becomes more important when selecting investment options. When evaluating 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, in addition to the expense ratio, can vary dramatically among seemingly similar passive index funds and ETFs.

Here are 5 key costs to consider when checking out passive funds.

1. Cost of doing business: Expense ratios

The expense ratio is perhaps the fund cost that investors pay closest attention to. Each year, mutual funds and ETFs charge investors a fee to cover services such as investment management, recordkeeping, compliance, and shareholder services. In general, these costs are 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.

Tip: When comparing products that track the same index and whose performance is likely to be similar, expenses matter a great deal.

2. Ticket to ride: Transaction fees

When you make an investment in a mutual fund, there may be an up-front charge to buy shares called a transaction fee. Typically these are small costs, but they can add up.

For example, if you make regular contributions into a 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 make monthly purchases, a fee of this kind could add up to $900 a year and quickly outweigh minor differences in expense ratios.

When buying or selling an ETF, you may have to pay a trading commission. 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 these benefits against other characteristics of the funds or ETFs.

3. Mind the gap: Spreads

With mutual funds, anyone buying or selling on a given day gets the same price, known as the net asset value (NAV), which is typically set at the close of the market. But ETFs shares trade on the secondary market, which means the price is set each day by buyers and sellers. The difference between the prices at which people are willing to buy and sell is called the bid-ask spread, and for some ETFs it can add up 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 at the prevailing asking price of $50.50, 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.

Tip: Typically, ETFs with the highest trading volume will have the smallest spreads. So if multiple ETFs exist that meet your goals, you should consider liquidity as part of your selection process.

4. Factor in performance: Tracking error

Passive strategies are designed to track the performance of an index. That may sound simple, but it's not. To some extent, all passive products will differ from the performance of an index. This difference between ETF performance and index performance is known as "tracking error."

Tracking error 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 error is better.

5. Consider what you keep: Taxes

When a fund sells stocks in its portfolio to realize profits, reinvest, or raise cash to pay investors who are leaving the fund, it can create taxable capital gains, which the fund usually has to distribute to shareholders. Any taxes paid on these gains reduce an investor's after-tax return. All funds have the potential to generate capital gains, 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, the ways that different funds replicate indexes, manage taxes, and rebalance can all affect capital gains.

Tip: If you are investing in a 401(k) or IRA, taxes on fund distributions aren't an important consideration. If you are investing through a taxable account, though, look back at historic capital gains distributions and fund turnover to get a sense of the tax efficiency of the investment options.

Next steps to consider



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