Courtesy of Jason Zweig / WSJ Columnist
On Sept. 21, Charles Schwab, SCHW -0.74%the discount broker, cranked up its publicity machine to announce it is cutting expenses on its 15 exchange-traded funds, or ETFs, by an average of 50%, to as low as 0.04%. Invest $10,000 and you can pay as little as $4 a year.
Could expenses go to zero? “Well, with our pricing adjustment, they do round to zero,” quips Marie Chandoha, president of Charles Schwab Investment Management. Schwab isn’t alone: 16 ETFs charge less than 0.1% in annual expenses, according to XTF.com, an ETF-rating website. Investing is within spitting distance of becoming free—and that is unambiguously worth celebrating.
Nevertheless, investors need to bear in mind that annual expenses are the most visible—but far from the only—cost of an ETF. Even as annual expenses race toward zero, you can still get clipped on other costs if you aren’t careful.
Let’s take a moment to put what is happening into historical perspective. In 1976, Vanguard Group introduced First Index Investment Trust (now the Vanguard 500 Index Fund ), which sought to replicate the return of the Standard & Poor’s 500-stock average. The fund’s expenses the first year, says Vanguard’s founder, John C. Bogle, ran at 0.43%.
Today, the cost of a $10,000 account in the same portfolio—now available both as the Vanguard 500 Index mutual fund and the Vanguard S&P 500 VOO -0.45%ETF—is as low as 0.05%. That is less than one-eighth what the same portfolio cost a generation ago and roughly 98% less than what a conventional mutual fund cost in the 1970s.
“There’s still lots of room for improvement” on fees, says Vanguard’s chief investment officer, Gus Sauter. “There’s a tremendous amount of [downward] pricing pressure in the marketplace now.”
In a presentation to a Barclays Capital conference on Sept. 10, BlackRock BLK -0.35%Chairman Laurence D. Fink, whose company manages the $527 billion iShares ETFs, said the firm will soon cut fees on a few major funds whose expenses have been undercut by competitors.
Among the likely candidates, analysts speculate, are iShares’ MSCI Emerging Markets Index Fund EEM -0.61%and Barclays Aggregate Bond Fund, AGG +0.14%which are rivaled by comparable funds at Vanguard and Schwab that charge much lower annual expenses. A BlackRock spokeswoman declined to elaborate on Mr. Fink’s remarks.
State Street Global Advisors‘ STT -0.19%SPDR S&P 500, SPY -0.46%the oldest and largest ETF, charges 0.09% in annual expenses, down from 0.20% at its birth in 1993. “At this point in time, we don’t see it going lower,” says James Ross, managing director at the SPDR funds. “Could it go lower? Absolutely. It’s a living, breathing product.”
Besides annual expenses, there are several other costs you need to control.”Tracking error,” which you can monitor on most ETF websites or on Morningstar.com, measures how far a fund’s return wanders from that of its underlying benchmark. If an ETF consistently or widely underperforms the index it is meant to track, that takes money out of your pocket.
Morningstar.com or most ETFs’ websites report the number in various ways, sometimes as “tracking volatility.” Add it to the annual expense ratio to see if a fund is still cheaper than its rivals.
What traders call the “spread” is the gap between the “bid” price (what buyers are willing to pay) and the “ask” (what sellers are willing to accept). Use a “limit order” with a specified buying price, and favor the most-liquid ETFs, whose spread can be as narrow as one penny.
During the day, an ETF can trade at prices slightly above or below the sum of all its securities. If you buy when the ETF’s price is above the net asset value of its underlying holdings, you have paid a “premium”; buy when it momentarily is depressed and you got it at a discount.
You can see a fund’s “indicated net asset value,” or INAV, on Yahoo Finance by first typing ^ followed by the fund’s ticker symbol and then -IV; compare that to the market price by typing in only the fund’s ticker. A widely traded U.S. stock ETF should trade well within 0.1% of its INAV. If the premium is larger, wait to buy until it narrows.
Chris Hempstead, head of ETF trading at brokerage firm WallachBeth Capital in New York, suggests not placing any trades in an ETF as the market first opens in the morning, when prices of the underlying securities are still in flux. Unless you wait to trade until at least five minutes after the market opens, he warns, you could pay both a wider brokerage spread and a bigger premium than is necessary.
Investing has never been cheaper. Make sure you don’t spoil the gift of nearly costless funds by incurring