Most ETFs (Exchange Traded Funds) passively track a benchmark index, such as the S&P 500. The best ETFs to buy are often those with the lowest expenses.
Low expenses are one of the top advantages of ETFs and index-based mutual funds. This is why investors should be aware of ETF fees and expenses before buying the right funds for their needs.
Learn more about ETF fees, how they are deducted from your investment, and how they impact fund performance.
Expense Ratios and How ETF Fees Work
When researching or looking at information on ETFs or mutual funds, one of the first pieces of information to look for is the expense ratio. Expressed as a percentage, it is a management fee that is deducted from the fund's assets.
Fees for ETFs (and mutual funds) are deducted to pay for the fund's management and operational costs. This means they are also taken out of your earnings. The lower the fees, the more of your share of the fund's profits you get to keep.
Example of How ETF Fees Are Deducted
If an ETF or mutual fund has an expense ratio of 0.50%, the fund's expenses are 0.50% of the fund's assets under management. The investment company managing the fund would deduct half of one percent from the fund's assets on an annual basis.
You would receive the total return of the ETF, minus the expenses. If the fund's total return (before expenses) during a year is 10.00%, and the expense ratio is 0.50%, the net return to you (after expenses) would be 9.50%.
An expense ratio of 0.50% translates to expenses of $5 for every $1,000 you invest.
Why ETF Fees Matter
Most ETFs are passively managed, so their expense ratios tend to be lower than most mutual funds. Since ETFs simply track a benchmark index, there is no need for a fund manager to research, analyze, or make trades.
When these costly activities are removed, the expense of operating the fund is lower. An actively managed mutual fund, by contrast, costs more to operate, so it has higher fees.
Typical expense ratios for mutual funds will range from about 0.50% to 2.00%. ETF fees, on the other hand, range from as little as 0.05% to about 1.00%.
The lowest-cost ETFs usually have lower expense ratios than the lowest-cost index mutual funds.
For example, one of the most widely traded ETFs is the SPDR S&P 500 (SPY). It has an expense ratio of just 0.0945%.
Through September 30, 2020, SPY had a 10-year annualized return of 13.74%. One popular actively managed mutual fund with similar holdings is The Growth Fund of America (AGHTX), which has an expense ratio of 0.64%. AGHTX had a 10-year annualized return of 13.26% through October 31, 2020.
If you had invested money in AGHTX, you not only would have earned less than the same amount in SPY but also would have lost more of your return to expenses.
ETF Fees and Finding the Best Funds
The ETFs that have the lowest fees are not always the best funds to buy. Before buying an ETF, compare it to other similar funds.
For example, be sure that the ETFs you are comparing track the same index. It also helps to look at performance history and total assets.
The fund's total assets are important to analyze. Larger assets generally mean greater liquidity. This can impact an ETF's performance, especially in the short run. ETFs with more assets are generally safer investments than those with much lower assets.
One growing trend among some of the largest brokerage houses is 0% fees on a select group of funds. For example, Fidelity Investments offers the following 0% funds:
- Fidelity ZERO Large Cap Index Fund (FNILX)
- Fidelity ZERO Extended Market Index Fund (FZIPX)
- Fidelity ZERO Total Market Index Fund (FZROX)
- Fidelity® ZERO International Index Fund (FZILX)
If you plan to invest in multiple funds, research their holdings to ensure there is minimal or no overlap in investments. This will help you diversify your investments and avoid being too reliant on a certain stock.
Smart investors do the research and comparisons on expense ratios before finding the best ETFs. When comparing ETFs that track the same index, the one with the lowest expense ratio is generally the best choice.
Frequently Asked Questions (FAQs)
What is an ETF?
An exchange-traded fund (ETF) is a fund that can be traded on an exchange like a stock. ETFs typically track an index, sector, commodity, or another asset. You own a portion of the ETF, but you don't own the underlying assets. ETFs are traded throughout the day.
How do you invest in an ETF?
To invest in an ETF, you'll need to open a brokerage account. There are many brokerage accounts to choose from, so consider each broker's features and fees. Many include educational features that can help you take advantage of your brokerage account. Next, research ETFs. Index funds are often a good starting point, but research your options and choose what works best for you.
The Balance does not provide tax or investment advice or financial services. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.