Skip to Content
ETF Specialist

Fee Limbo: How Low Can Expense Ratios Go?

As fees get squeezed, investors should refocus on the other costs they might be incurring.

Mentioned: , , , ,

Asset managers offering low-cost exchange-traded funds and index mutual funds are scraping their backs on the floor in a game of fee limbo. Late last year, Fidelity launched a quartet of zero-fee index mutual funds. In recent weeks we've seen a fresh round of expense-ratio reductions for some of the largest ETFs and index mutual funds. A number of novel new funds sporting competitive price tags have also come to market. SoFi, a financial-services upstart, filed for the first zero-fee ETF. Most recently, a newer entrant into the arena listed an ETF that will temporarily pay early investors to own it, the Salt Low truBeta US Market ETF (LSLT).

And the Winner Is?
There is no arguing that lower fees are good for investors. Every penny that stays out of a fund sponsor's pocket and continues to compound to investors' benefit over time is a penny worth fighting for.

Existing shareholders in the funds that have been further reducing their already paltry fees are clear winners in this fight. But as this race to the bottom draws ever nearer, well, the bottom, investors' savings are being measured in dollars and cents. Take for example, the JPMorgan BetaBuilders U.S. Equity ETF (BBUS). The fund was launched on March 12 and charges a fee of 0.02%. Assuming a $10,000 investment, this amounts to a dollar's worth of annual fee savings relative to its closest competition. In the case of  Vanguard Total Bond Market ETF (BND), the savings are smaller still. At 0.035% (yes, it is expressed to three decimal places), BND's new, lower expense ratio reflects $0.50 worth of annual fee savings on a $10,000 investment versus its most competitively priced peer,  SPDR Portfolio Aggregate Bond ETF (SPAB), which charges 0.04%. At the margin, the spoils to the victors aren't anything to write home about.

In my opinion, these latest volleys in the so-called "fee war" will likely do more to move the needle for fund firms and, where relevant, their affiliated brokerages than they will for investors. The amount of free publicity these fund launches and fee reductions have garnered (yes, including articles like this one) has likely paid dividends for their sponsors. And in some cases, like Fidelity's zero-fee suite, these funds are clearly loss leaders, a cheap gallon of milk meant to entice consumers into the back of the store in hopes that they'll grab some Cheetos and a pack of gum before they get to the counter.

Fees Still Matter, but Maybe Not as Much as They Used To
As fund fees continue to inch lower, it's important that investors be mindful of other considerations that will have far more meaningful long-term implications for their investments than saving a buck or two on fund fees. The top three in my mind are: portfolio construction, taxes and transaction costs, and opportunity costs.

Portfolio Construction
Portfolio construction matters. More specifically, in the case of index-tracking ETFs and mutual funds, index construction matters. Minor differences in seemingly similar funds' fees are less meaningful still when scaled against the differences in their long-term returns--which can be many multiples larger. For example, the four least-expensive ETFs in the large-value Morningstar Category have a fee spread of just 0.01%. The costliest charges 0.05%, the least expensive ones charge 0.04%. Meanwhile, the difference between the returns of the best- and worst-performing fund in this group amounted to 1.64% annualized for the five-year period through March 12, 2019. It just so happens that the best-performing fund in this case was the most "expensive" of the four--the one that levies a fee that is a basis point higher than its peers. As fees converge at ever-lower levels, understanding the particulars of index construction and their implications for these funds' performance profiles matters more than ever.

Taxes and Transaction Costs
Taxes and transaction costs are a critical consideration. While some investors might be tempted to save a few bucks by switching from one low-fee fund to another, it is important to understand that doing so could be a value-neutral proposition at best.

Switching from one low-fee fund to another in a taxable account is a bad idea. As an example, let's do some back-of-the-envelope math to assess the tax implications and cost savings of a hypothetical switch. Assume I invested $10,000 in  iShares Core S&P Total U.S. Stock Market ETF (ITOT) five years ago and liquidated the position on March 12, 2019. If I made this transaction in a taxable account and assume a 15% long-term capital gains tax rate, this would have resulted in a tax bill of approximately $949. Assume that I then reinvested the proceeds in BBUS to save about $1.54 on fees the next year. Was this worth it? Absolutely not. It'd take many a lifetime to recoup the costs of my self-inflicted tax bill.

Note that my example above ignores other costs that might be incurred in making these transactions (commissions, bid-ask spreads, and so on). It's likely that these transaction costs could consume years' worth of prospective fee savings. So even in tax-sheltered accounts, it's probably a bad idea to switch from one fund to another in hopes of saving a few bucks. That said, depending on investors' circumstances, they might still consider lower-fee alternatives for incremental investments.

Opportunity Costs
As explicit costs like fund fees and commissions get squeezed, investors should be on the lookout for other costs they might incur. These costs are less transparent. The most meaningful among them take the form of opportunity costs. A prime example of such an opportunity cost is foregone yield on cash balances. Look at what you're earning on your cash. What's the yield on your cash sweep or money market account? In many cases, these yields are measly. The difference between one year's interest earning 0.50% and 2% on a $10,000 cash balance amounts to $150. This is many multiples what investors might save being fee misers.



Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.