By Jeff Brown
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
zero-fee 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 stock-market 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.
Mr. Brown is a writer in Livingston, Mont. You can email him at
reports@wsj.com.
(END) Dow Jones Newswires
October 21, 2018 22:59 ET (02:59 GMT)
Copyright (c) 2018 Dow Jones & Company, Inc.
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