Index funds and ETFs: Shop smart

Costs can vary dramatically among passive investments like ETFs and index funds.

  • Investing Strategies
  • Exchange-Traded Funds
  • Exchange-Traded Notes
  • Index Funds
  • Investing Strategies
  • Exchange-Traded Funds
  • Exchange-Traded Notes
  • Index Funds
  • Investing Strategies
  • Exchange-Traded Funds
  • Exchange-Traded Notes
  • Index Funds
  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

Key takeaways

Weighing the costs of passive investments:

  • Even small differences in expense ratios can have an impact.
  • Consider any transaction costs and commissions.
  • The bid-ask spread varies for ETFs.
  • Tracking error and taxes may impact returns.

From 2007 through 2016, domestic equity index mutual funds and ETFs received more than $1.4 trillion in cumulative net new cash and reinvested dividends, while actively managed domestic stock funds saw net outflows of $1.1 trillion.1

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 the market. Passive ETFs and mutual funds, on the other hand, try to match the performance of the market, or a part of it, based on an index, for instance the S&P 500. These investments may not offer the potential of outperformance, but they typically offer lower costs.

Once you limit the potential for outperformance, issues of costs becomes 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 charge, but it's not the only one. And costs can vary dramatically among seemingly similar passive ETFs and index funds.

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

The cost of doing business: expense ratios

Perhaps the most closely watched fund cost is the expense ratio. Each year index funds and ETFs charge investors a fee to cover services such as recordkeeping, paying distributions, compliance, and shareholder services. In general, this 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, there are 25 large-cap-blend index funds available to Fidelity's brokerage customers, most of which track the S&P 500® Index. But the expense ratios range from 0.015% to more than 1.5%. Likewise, of the 30 passively managed domestic large-cap, core-blend cap-weighted equity ETFs on Fidelity's platform, expense ratios range from just 0.03% to 0.60%.

These differences may appear small, but even small differences add up. Hypothetically, if you invested $50,000 in a fund or ETF with annual operating expenses of 0.01% for 10 years with 5% annual returns, you would end up with $81,363 after $65 in fees, before taxes. The same hypothetical 5% annual return in a fund or ETF that charged 1.56% would have left you with a final balance of $69,472 after fees of $9,413. That is a difference of more than 15%.2

Tip: When comparing products where performance is likely to be similar, expenses matter a great deal.

Buy a 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 3, in the Fidelity mutual fund research center there are about 429 index funds mutual funds, and more than 250 charged transaction fees. With an ETF, you have to pay a brokerage commission. These are typically relatively small costs, but there are times when they can add up.

One 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: Check with your broker to see if it 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 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 share 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 29 domestic energy ETFs (excluding leveraged and inverse products), the average monthly bid-ask spread ratio goes from 0.02% to 1.85%.3

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 is not easy to do. Indeed, all passive products will differ from the performance of an index to some degree. This variation in 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: tax expense

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 going 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.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.

Next steps to consider

See Fidelity's pricing

See how Fidelity funds and ETFs stack up to the competition.

Find mutual funds and ETFs

Find and compare thousands of other index funds and ETFs

Learn more about funds

Visit Fidelity's Learning Center for in-depth education.