ETF Fees Deducted From Your Investment

Find Out How ETF Fees Are Deducted and How They Affect Performance

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Since most ETFs 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.

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. The expense ratio, expressed as a percentage, is a management fee that is deducted from the fund's assets. These fees for ETFs (and mutual funds) are deducted to pay for the fund's management and operational costs.

ETF fees and expenses are typically lower compared to their investment cousins, mutual funds. Similar to mutual funds, ETF fees that are included in the expense ratio are not deducted or withdrawn directly from the investor's account; these fees are taken from the fund's assets before they are included in the investors assets.

Example of How ETF Fees Are Deducted

To understand ETF fees and expenses, consider an example of an ETF or mutual fund that has an expense ratio of 0.50. This means that the fund's expenses are 0.50% of the fund's assets under management. In this example, the investment company managing the fund would deduct half of one percent from the fund's assets on an annual basis.

The investor will receive the total return of the ETF, less the expenses. For example, if the fund's total return (before expenses) during a year is 10.00%, and the expense ratio is 0.50 percent, the net return to the investor (after expenses) would be 9.50%. Doing some quick math, an expense ratio of 0.5% translates to expenses of $5 for every $1,000 invested.

Why ETF Fees Matter

Since the majority of ETFs are passively-managed, their expense ratios tend to be much lower compared to most mutual funds. Since ETFs simply track a benchmark index, there is no need for a fund manager to research, analyze, or trade securities. When these costly activities are eliminated, the expense of operating the fund is lower, as compared to an actively-managed mutual fund.

Typical expense ratios for mutual funds will range from about 0.50% to 2.00%, whereas ETF fees range from as little as 0.05% to about 1.00%. Therefore 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), which has an expense ratio of just 0.0945%. Through September 30, 2020, SPY had a 10-year annualized return of 13.74%. A 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.

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, be sure to make apples-to-apples comparisons. For example, be sure that the ETFs you are comparing track the same index. It also helps to look at the performance history and the fund's total assets.

The fund's total assets are important to analyze because larger assets generally mean greater liquidity, which can impact an ETF's performance, especially in the short run. Therefore, ETFs with more assets are generally preferable to those with significantly lower assets.

A growing trend among some of the largest brokerage houses, however, is 0% fees on a select group of funds. As an 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), and the Fidelity® ZERO International Index Fund (FZILX).

Another consideration if you plan to invest in multiple funds, is to research their holdings to ensure there is minimal or no overlap in investments. By doing so, you will avoid being overly weighted in a certain stock, which would defeat the purpose of diversification. As an example, if you decide to purchase three different funds and the top holding of all three happens to be Apple (AAPL), your portfolio returns might be too reliant on the success of one company.

The Bottom Line

Smart investors do the research and comparisons on expense ratios before finding the best ETFs. When comparing ETFs that track the same index, the ETF with the lowest expense ratio is generally the best choice. In addition, ETFs generally have lower expense ratios than mutual funds.

The Balance does not provide tax, investment, or financial services and advice. 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.