Exchange-traded index funds are a bit like mobile phones -- models offer an increasing array of features over time, while prices on even the plain-vanilla models keep falling.
So, in step, prices have been dropping lately on garden-variety ETF index expenses. Typically these have offered rock-bottom costs on most products, relative to actively managed mutual funds. Yet there are several components of ETF pricing, so you need to be careful. You could miss some of the nuances and pay more than you should.
The good news is that competition is forcing expense ratios down to near-institutional-pricing levels. Now you can pay roughly what big money managers do for entire baskets of stocks, bonds and other vehicles. (An expense ratio is what a money-management firm charges you every year for owning their ETFs -- a percentage based on assets under management. Generally, the lower the expense ratio, the better, since more of your money is being invested and not going into the manager's pocket.)
The latest salvo of price cuts came from the discount broker Charles Schwab, which recently reduced fees by up to 59 percent on its 15 ETFs, which hold more than $7 billion in assets. Schwab is trying to play catch-up with the three giants in the field -- Blackstone/iShares, State Street's SPDRs and Vanguard Group -- which offer an even wider selection of low-cost ETFs.
Expenses on Schwab funds range from 0.04 percent for its Multi-Cap Core Fund to 0.20 percent for its International Small/Mid-Cap Growth fund. How does that compare with previous levels? Expenses on the Mid-Cap ETF were cut in half, from 0.13 percent to 0.07 percent, while others were trimmed by as little as 0.02 percentage points.
While this sounds like counting pennies, it makes a difference over time. Say you had a large-company stock fund in your 401(k), had $100,000 invested and were paying 1 percent annually. Drop that expense to 0.04 percent and you'd have $107,000 more if your fund returned 5 percent annually over 30 years, according to the Securities and Exchange Commission's Mutual Fund Cost Analyzer (http://www.sec.gov/investor/tools/mfcc/mfcc-intsec.htm). The SEC's calculator shows money lost to expenses and forgone earnings -- gains you would've made if expenses were lower.
If expense ratios were all you needed to scout when buying an ETF, I would suggest that you buy the cheapest index ETFs possible to cover stock, bond, real estate and commodities markets across the world. But here's what else you need to consider:
1. Look at the bid/ask spread.
Since ETFs are traded on exchanges, the spread is the difference between the highest and lowest prices for buying and selling. Generally, the smaller, or "tighter," the spread, the better for you, the investor. Higher bid/ask spreads mean you're paying a premium for ETFs, which adds to your transaction costs. According to the website Indexuniverse.com, which tracks index funds, bid/ask spreads on the Schwab group, for example, are as high as 0.12 percent for the Schwab International Equity ETF. When you're shopping for ETFs, look for the funds with the lowest bid/ask spreads, which can be as little as a penny for large ETFs such as the Vanguard S&P 500 ETF.
2. How large is the average capitalization of the securities within the ETF?
ETFs containing megacap blue-chip stocks generally have the tightest bid/ask spreads because the stocks within the fund are highly liquid. As you get lower down the food chain into thinly traded small-cap or international stocks and other vehicles such as real estate investment trusts, the bid/ask spreads widen.
3. How closely does the ETF track an underlying index?
Some track more closely than others. ETFs following large, widely followed indexes such as the S&P 500 should be really close to the underlying benchmark. If they don't track an index closely -- more than 0.10 percent variation is a warning sign -- that means you're veering further away from the total return on your chosen basket of securities.
4. What kind of trading commission are you paying?
Since ETFs are securities traded on an exchange, you have to go through a broker to buy and sell them. Deep-discount online brokers typically offer the lowest commissions, but many large mutual-fund managers offer commission-free ETFs on a select group of ETFs, which are typically their most popular funds.
As you become more discerning about the total cost of ETF ownership, consider replacing actively managed mutual funds in your retirement and other portfolios such as 529 college savings plans with ETFs.
A good place to start is your 401(k) portfolio. Under new Department of Labor disclosure rules, your employer is required to disclose the expense ratios and the actual dollar amounts you pay for each fund in your plan. How much are you paying and how much can you save?
If you're paying more than 0.50 percent annually for any fund, it's time to ask your employer to find lower-cost funds. Since it's likely that you're paying the expenses on the funds within your portfolio, any savings you can reap can help improve your total performance. As I've illustrated above, even seemingly small cuts in expenses can help you accumulate bigger returns over time.
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