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Index funds and ETFs: Shop smart

December 2014 | Five key costs to consider when checking out passive funds.By FIDELITY VIEWPOINTS

From 2007 through 2013, domestic equity index mutual funds and ETFs received $795 billion in cumulative net new cash and reinvested dividends, as many investors were drawn to passive investment strategies.1

A big part of the allure of passive investments is their relatively low cost. Rather than attempting to beat the market through active stock picking, these passive strategies try to match the performance of the market or a part of it, based on an index, for instance the S&P. These investments may not offer the potential of outperformance, but they typically offer lower costs.

Once you take performance out of the equation, fees and expenses associated with these investments become even more important factors in differentiating investment options.

Here are five 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 there is still a range of costs.

In fact, there are 13 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 0.05% to 1.56%. Likewise, of the 49 domestic large core-blend cap-weighted equity ETFs on Fidelity’s platform, expense ratios range from just 0.04% to 1.25%.

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 0.05% for 10 years with 5% annual returns, you would end up with $81,038 after $321 in fees. The same hypothetical 5% annual return in a fund or ETF that charged 1.56% would have left you with a final balance of $69,681 after fees of $9,250. That is almost 15% less.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 fund, there may be a transaction fee. 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 add up.

Tip: Check with your broker to see if they offer 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 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. Using Fidelity’s ETF screener, you can research the average monthly bid-ask ratio. For example, If you look at the 39 domestic energy ETFs (excluding leveraged and inverse products), the average monthly bid-ask spread ratio goes from 0.05% to 0.51%.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 error

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 difference 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 to that of competitors and the underlying index. All things being equal, a lower tracking error is better.

Consider what you keep: tax expense

When a fund experiences a capital gain, it has to pass that tax liability on to shareholders. Those taxes come straight from an investor’s return. All funds are going to generate taxes, 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. How the 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 aren’t an important consideration. Otherwise, look back at historic capital gains distributions and turnover to get a sense of the tax efficiency of the options. Fidelity’s ETF screener lets you measure the tax cost ratio to get a sense of historic tax impact.

Learn more

Before investing, consider the investment objectives, risks, charges, and expenses of the fund, exchange-traded fund, or annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus and, if available for the options, a prospectus or summary prospectus containing this information. Read it carefully.

1. ICI Factbook, 2014.

2. Hypothetical fund performance calculated using the FINRA mutual fund analyzer.

3. Screen performed using Fidelity’s ETF/ETP screener as of 11/5. The screen excluded leveraged and inverse ETFs.

Investing involves risk, including risk of loss.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

For iShares® ETFs, Fidelity receives compensation from the ETF sponsor and/or its affiliates in connection with an exclusive, long-term marketing program that includes promotion of iShares ETFs and inclusion of iShares funds in certain FBS platforms and investment programs. Additional information about the sources, amounts, and terms of compensation is described in the ETF’s prospectus and related documents. Fidelity may add or waive commissions on ETFs without prior notice. BlackRock and iShares are registered trademarks of BlackRock, Inc., and its affiliates.

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 risk, 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 errors. 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). Each ETP has a unique risk profile that is detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

The Fidelity ETF/ETP Screener is a research tool provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with pre-selected criteria (including expert ones) are solely for the convenience of the user. Expert Screens are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these Screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange traded products or closed end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from their use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation and other individual factors and re-evaluate them on a periodic basis.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917

703306.3.0

This content was provided by Fidelity Investments and did not involve the Kiplinger editorial staff.

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