(The author is a Reuters columnist and the opinions expressedare his own. For more from John Wasik see )
By John Wasik
CHICAGO, Oct 8 (Reuters) - Exchange-traded index funds are abit like mobile phones -- models offer an increasing array offeatures over time, while prices on even the plain-vanillamodels keep falling.
So, in step, prices have been dropping lately ongarden-variety ETF index expenses. Typically these have offeredrock-bottom costs on most products, relative to actively managedmutual funds. Yet there are several components of ETF pricing,so you need to be careful. You could miss some of the nuancesand pay more than you should.
The good news is that competition is forcing expense ratiosdown to near-institutional-pricing levels. Now you can payroughly what big money managers do for entire baskets of stocks,bonds and other vehicles. (An expense ratio is what amoney-management firm charges you every year for owning theirETFs -- a percentage based on assets under management.Generally, the lower the expense ratio, the better, since moreof your money is being invested and not going into the manager'spocket.)
The latest salvo of price cuts came from the discount brokerCharles Schwab, which recently reduced fees by up to 59 percenton its 15 ETFs, which hold more than $7 billion in assets.Schwab is trying to play catch-up with the three giants in thefield -- Blackstone/iShares, State Street's SPDRs and VanguardGroup -- which offer an even wider selection of low-cost ETFs.
Expenses on Schwab funds range from 0.04 percent for itsMulti-Cap Core Fund to 0.20 percent for itsInternational Small/Mid-Cap Growth fund . How does thatcompare with previous levels? Expenses on the Mid-Cap ETF
were cut in half, from 0.13 percent to 0.07 percent,while others were trimmed by as little as 0.02 percentagepoints.
While this sounds like counting pennies, it makes adifference over time. Say you had a large-company stock fund inyour 401(k), had $100,000 invested and were paying 1 percentannually. Drop that expense to 0.04 percent and you'd have$107,000 more if your fund returned 5 percent annually over 30years, according to the Securities and Exchange Commission'sMutual Fund Cost Analyzer ().
The SEC's calculator shows money lost to expenses and forgoneearnings -- gains you would've made if expenses were lower.
If expense ratios were all you needed to scout when buyingan ETF, I would suggest that you buy the cheapest index ETFspossible to cover stock, bond, real estate and commoditiesmarkets across the world. But here's what else you need toconsider:
1. Look at the bid/ask spread.
Since ETFs are traded on exchanges, the spread is thedifference between the highest and lowest prices for buying andselling. Generally, the smaller, or "tighter," the spread, thebetter for you, the investor. Higher bid/ask spreads mean you'repaying a premium for ETFs, which adds to your transaction costs.According to the website Indexuniverse.com, which tracks indexfunds, bid/ask spreads on the Schwab group, for example, are ashigh as 0.12 percent for the Schwab International Equity ETF. When you're shopping for ETFs, look for the funds withthe lowest bid/ask spreads, which can be as little as a pennyfor large ETFs such as the Vanguard S&P 500 ETF .
2. How large is the average capitalization of the securitieswithin the ETF?
ETFs containing megacap blue-chip stocks generally have thetightest bid/ask spreads because the stocks within the fund arehighly liquid. As you get lower down the food chain into thinlytraded small-cap or international stocks and other vehicles suchas real estate investment trusts, the bid/ask spreads widen.
3. How closely does the ETF track an underlying index?
Some track more closely than others. ETFs following large,widely followed indexes such as the S&P 500 should be reallyclose to the underlying benchmark. If they don't track an indexclosely -- more than 0.10 percent variation is a warning sign --that means you're veering further away from the total return onyour chosen basket of securities.
4. What kind of trading commission are you paying?
Since ETFs are securities traded on an exchange, you have togo through a broker to buy and sell them. Deep-discount onlinebrokers typically offer the lowest commissions, but many largemutual-fund managers offer commission-free ETFs on a selectgroup of ETFs, which are typically their most popular funds.
As you become more discerning about the total cost of ETFownership, consider replacing actively managed mutual funds inyour retirement and other portfolios such as 529 college savingsplans with ETFs.
A good place to start is your 401(k) portfolio. Under newDepartment of Labor disclosure rules, your employer is requiredto disclose the expense ratios and the actual dollar amounts youpay for each fund in your plan. How much are you paying and howmuch can you save?
If you're paying more than 0.50 percent annually for anyfund, it's time to ask your employer to find lower-cost funds.Since it's likely that you're paying the expenses on the fundswithin your portfolio, any savings you can reap can help improveyour total performance. As I've illustrated above, evenseemingly small cuts in expenses can help you accumulate biggerreturns over time.
(Editing By Heather Struck, Beth Pinsker Gladstone and DouglasRoyalty)
Keywords: COLUMN WASIK/ETFPRICE