Why fund investors should look beyond fees
Funds tracking the same index can produce different results for reasons other than fees
Fidelity Investments recently escalated the cost-cutting wars among index-fund giants such as Vanguard Group, Charles Schwab Corp. and State Street Corp. by launching four index funds that charge no management fees.
The zero-fee funds are the latest salvo in a years’ long price war among fund firms seeking to attract cost-conscious investors who have been flocking to plain vanilla funds that track indexes like the S&P 500, instead of spending big money on funds run by hotshot managers.
But the race to zero has also left some investors wondering: In a world where fees are so low already, should cost be the most important factor when choosing among funds that track the same index?
Investing experts say funds tracking the same index aren’t necessarily clones, which is why investors shouldn’t base their buying decisions on fees alone. Indeed, some funds do a better job mirroring the returns of their underlying index than seemingly identical peers, and the reasons for that can be found under a fund’s hood. Practices such as sampling (when a fund holds a sample of securities in an index rather than fully replicating it), use of derivatives, turnover, tax management and securities lending can lead to different results among funds tracking the same index. Details on fund policies are available from research firms such as Morningstar Inc. and in fund disclosures, including the prospectus.
“Just because a fund calls itself an index fund doesn’t mean it will have exactly the same holdings as the benchmark,” says Andy Kapyrin, partner and director of research at wealth-management firm RegentAtlantic in Morristown, N.J. Some do strive to own all the securities in the underlying index, some choose a representative sample that may allow for “small differences,” he says. Reality check Fees, or “expense ratios,” are a percentage of the investor’s holdings charged for managing the fund. While investors pay about 0.6% on average for actively managed funds, index funds typically charge less than 0.1%, according to industry trade group Investment Company Institute. Index investors pay less because they are content to match market gains rather than taking bigger risks swinging for the fences.
At the end of 2017, 37% of all assets in U.S. mutual funds and exchange-traded funds were in index funds, up from 3% in 1995 and 14% in 2005, according to the Federal Reserve Bank of Boston.
Low fees are such a big selling point that fund firms have engaged in a price war. This summer, Fidelity launched four zerofee funds: Fidelity ZERO Large Cap Index (FNILX) and Fidelity ZERO Extended Market Index (FZIPX), Fidelity ZERO Total Market Index (FZROX), Fidelity ZERO International Index (FZILX). Already, the funds have amassed close to $1.5 billion in assets, according to Morningstar.
But that doesn’t necessarily mean investors should dump similar index products they have already. Daniel Kern, chief investment officer at TFC Financial Management in Boston, recommends a reality check.
“The difference in cost between Fidelity’s ZERO Total
Market Index fund and competing funds offered by Schwab, BlackRock Inc.’s iShares and State Street is 0.03%,” he says. “For someone investing $10,000, the cost savings amounts to only $3 a year,” he says. “The tax and/ or transaction costs associated with switching from an existing index fund holding would be far higher than the cost savings for many consumers.”
Even if the fund is held in an IRA or 401(k), and thus protected from immediate taxes on gains after a sale, there is no guarantee the cheaper fund will do better. Derek Hagen, founder of Hagen Financial in Minneapolis, says that, in addition to looking at return data, fund shoppers should look at “tracking error,” a gauge of how well a fund mirrors the performance of its index.
“Ideally, you would like to see the fund have tracking error that is less than or equal to the expense ratio,” Mr. Hagen says. That would mean the error is caused by the expenses and not some mismatch in the fund’s holdings and the index.
Tracking error can arise from various factors, like a fund owning just a sample of securities in the index or employing options or futures contracts to stand in for hard-to-trade securities. Small and foreign stocks and bonds, for example, may be expensive to buy and sell due to large spreads between bid and asked prices, so a sample or derivative may be used instead.
“Funds tracking broad stockmarket indices like the S&P 500 rarely have trading problems, but funds that track indices of foreign stocks or smaller companies can deviate from the value of the underlying holdings,” Mr. Kapyrin says.
He says ETFs, which trade like stocks, typically track their indexes very well, but that investors should be wary of those with a large bid/ask spreads, caused by differences in supply and demand. A large spread means you are paying more than what you could get if you wanted to sell the fund immediately. Turnover’s effect Tracking error also can be enlarged by turnover, or the percentage of a fund’s total value that changes hands each year due to investor purchases and redemptions. Lots of redemptions force the fund to sell assets to pay the departing shareholders. This can increase a fund’s costs and result in poor timing, such as buying when prices are up and selling when they’re down.
For investors using taxable accounts, sales of profitable assets to meet redemptions can trigger tax bills on profits paid out to shareholders in year-end distributions. For these shareholders, the index product with lower turnover would generally be best. (Redemptions aren’t an issue with ETFs because investors who get out simply sell shares to other investors, and the fund company doesn’t have to sell holdings to raise cash.)
Some funds try to curb turnover by prohibiting investors from buying shares soon after selling them. Long-term investors might value that.
And some fund managers strive to reduce the gains booked in these forced asset sales by selling the assets purchased at the highest prices. That’s possible because index funds must buy and sell the same securities over and over as investors move money in and out, so different blocks are purchased at varying prices.
Mr. Hagen says some fund managers offset expenses and reduce tracking error by lending securities for a fee to short sellers.
“Securities lending is a source of revenue for many index funds,” Mr. Kern says. Details on lending can be found in the fund’s Statement of Additional Information (SAI), he says.