Exchange-traded fund providers, including Vanguard, Charles Schwab and BlackRock's iShares, have been slashing the expense ratios on their index ETFs in the past two years, trying to one-up each other and win more of your investing money.
The stakes are high among the ETF industry giants, as investors embrace the passive style of fund management in greater numbers. The exchange-traded fund industry reached more than $1.9 trillion in assets at the end of August, according to ETF.com data, and 2013 saw a record level of flows into ETFs—$188 billion.
But the big question for the investor is not what the cost will be to the fund companies as they engage in a race to the bottom with fund fees, but instead: What benefit will it be to your financial future? Lower fund fees are great, but the fee war is not as simple an "investor win" as it appears.
"Our investors and advisors let us know that's what they wanted," said John Sturiale, senior vice president of product management at Schwab, which was a later entrant to the ETF price wars but has been a player for about the past two years.
A brief history of the fee war: In summer 2012, Malvern, Pennsylvania-based Vanguard lowered fees on 10 products within the four fund styles it considers core—U.S. stocks and bonds, and international stocks and bonds—to a range from 0.05 percent to 0.20 percent. In September 2012, Schwab cut expense ratios on 15 of its core ETFs to a range from 0.04 percent to 0.19 percent.
This past June, iShares repackaged its core ETF offerings—which many market watchers say was due to Vanguard's big gains in the ETF space—adding four and repricing or renaming six, so that their expense ratios range from 0.07 percent to 0.18 percent. Even Boston-based Fidelity Investments, long thought of as the king of the actively managed space, late last year introduced 10 ETFs that all have an expense ratio of 0.12 percent.
The expense ratio is often the simplest measure of an ETF's cost, but it's not the only consideration. There are four more crucial questions to ask yourself if you want to win the ETF price war as an investor.
There's no doubt the price cuts attract assets. A report by Vanguard found that in the 10 years ending Dec. 2012, the lowest quartile of index funds by expense ratio was the only quartile that attracted net positive cash flows. Almost $200 billion, or 81 percent of the cash flow, went to ultra-low cost funds, those with asset-weighted expense ratios of 0.05 percent.
But whether it's worth it for you to move is a simple question of math and time. A $250,000 portfolio compounding over 30 years at a 7.5 percent rate of interest is worth $2.2 million by the end. If you sliced the expense ratio by 0.5 percent and it compounded at 8 percent, it would be worth $2.5 million. If your money compounds over a long time—and this is one of the ETFs that hold a lot of money (more on that in a moment)—the move could be worth it.
After you decide which kinds of asset classes you want to hold in your portfolio, it makes sense to look at the ETFs offered by each of the big companies and compare expense ratios. But that's not all you should look at. There's a reason why those in-the-know in the ETF arena talk about "total cost of ownership" rather than just harping on low fees.
The tricky thing about index ETFs is that though they all purport to represent an asset class, like the S&P 500 or international stocks, they don't all go about it the same way. In fact, because of the way they are structured or managed, two index ETFs in the same asset class could have as much as a 0.5 percent-a-year difference in performance—even more, in many cases, than a difference in expense ratios, said Rob Nestor, head of iShares product strategy at BlackRock.
For instance, the $45 billion Vanguard ETF representing REITs (VNQ) has an expense ratio of 0.10 percent and a year-to-date return of 21.77 percent, according to David Kreinces, founder and portfolio manager of Thousand Oaks, California-based ETF Portfolio Management. The iShares ETF representing a comparable REIT universe (ICF) has an expense ratio of 0.35 percent and a year-to-date return of 23.2 percent.
"The higher return more than makes up for the expense ratio," said Kreinces, who uses the latter in the active portfolios he constructs for clients.
One clue about the composition of the index you're getting is the words "broad" or "total" in the title.
"If you're worried about getting indexes that are sliced and diced too thin, look at a total index," said Jim Rowley, senior investment analyst at Vanguard. "Of course, read further into exactly what it means, but that's a start."
The performance differences could come from the way the ETF is structured. For instance, one emerging markets ETF could include stocks from South Korea, while another excludes it because it is deemed a developed market. These kinds of country classification changes are not rare among the emerging market, frontier market, and developed market index funds. There have been some notable changes this year, and they relate to changes in the construction of the indexes that underlie the ETFs (MSCI, in fact, was considering moving South Korea into its developed market index earlier this year, though ultimately the index company decided not to make the move).
These classification changes, though notable, don't occur often enough to be nearly as important as the way the ETF is managed to minimize taxes on an ongoing basis. Law requires that as an ETF trades to track its index, it must pay capital gains and dividend taxes, which show up not on your individual statement, but in the performance of the fund. Different companies have different strategies for timing the sales of the securities so that the fund pays, for instance, the long-term capital gains tax rather than the higher, short-term tax.
You are most likely buying these ETFs to represent asset classes in your portfolio, or your advisor is buying them for you and holding them over the long term. But you will need to pay commissions on the trades. If your portfolio is rebalanced several times a year, those trades on a half-dozen or so ETFs could add up if you're being charged, say, $10 a trade.
The commissions you pay are largely a function of the brokerage platform you or your advisor uses. But some of the investment-product companies have struck deals with the brokerages, and some that are both product companies and brokerages have, of course, no charges on their in-house ETFs.
Schwab charges no commissions on its proprietary funds; Fidelity charges no commissions on its funds and has a deal with iShares not to charge commissions on its funds; Vanguard clients can also trade its ETFs commission-free.
The fund marketplace dynamic favors large funds, which have been able to drop their expense ratios and gather ever more assets. That makes it even harder for small funds to compete, and every year, dozens of smaller ETFs close, according to ETF.com. If you're invested in a fund that closes, you will face the hassle of reallocating to a new fund.
Since most of the largest ETF providers are the same ones offering the broad exposure, core ETFs at low expense ratios, risk of a fund closure is a less prominent issue. But there are minor ETF fee skirmishes going on among the next tier of players in the space—and among more specialized index products, such as smart beta—where the logic applies.
Say, for example, you are reviewing two Asian equity-income ETFs—one that has $100 million in assets and has been in existence for five years, and a brand-new ETF (i.e. no assets) that is being launched with an expense ratio 0.05 percent below the rival ETF.
You might not want to run to the new ETF just because the expense ratio is lower.
—By Elizabeth MacBride, special to CNBC.com