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Commission-Free or Lower-Fee ETFs?

Trading commissions are only one component of total cost for ETF investors.

Paul Justice, 03/16/2010

Over the past few months, some trading platforms have explicitly lowered investors' ETF costs by waiving trading commissions on a select few products. Charles Schwab launched eight of its own low-cost ETFs that can be traded for free on their own platform, and Fidelity recently partnered with iShares to bring 25 widely held ETFs to its users without the burden of an $8 fee per position entry or exit.

One thing is clear: Eliminating trading costs is an effective, transparent, and easy-to-quantify way to lower costs. Furthermore, over the long haul, keeping costs as low as possible--in tandem with proper asset allocation and realistic expectations--is perhaps the most effective way to meet your investment goals. In this regard, we have nothing but praise for these platform providers who are helping investors keep more of their own money.

Mutual Fund Benefits for Your ETFs?
Take the Fidelity move, for example. It is especially helpful for investors who have already decided that a broadly diversified portfolio of iShares ETFs is right for them, and they intend to continue making regular contributions to their portfolio. If investors continue making monthly contributions of $1,000 to any one of these funds, their annual returns increased by just $96 per year, or roughly 0.83%. Compounded over several years, these savings become a material benefit. Furthermore, that same investor can now take that same $1,000 per month, divide it up among any of the 25 offerings from iShares, and still pay no commission. Those investors no longer have to endure a suboptimal asset allocation because of prohibitive trading costs. Prior to the commission waiver, if you were making a single contribution to 10 different funds per month, you would have suffered from a $960 drag on $12,000 of contributions. Paying 8% in fees on your annual contributions is definitely one way to impair your long-term performance.

Of course, that same investor could have been using index mutual funds, which are widely available and have long been available without commission fees. But using mutual funds in a taxable account means that you would be sacrificing the great tax benefits and intraday liquidity that ETFs provide. In regard to investors making frequent contributions, the commission waiver puts the two products on equal footing from a contribution standpoint, and I believe that the product structure differentiation will translate into many investors now choosing ETFs over index funds.

Taxes, Liquidity, and More Still Matter
However, the Fidelity move does not necessarily mean that investors should drop their existing holdings and switch to an all ETF portfolio right away. The tax consequences of selling current holdings would likely dwarf the miniscule tax-efficiency benefits that cap-weighted ETFs hold over similarly structured mutual funds, if you are fortunate enough to have long-term capital gains on your current holdings. Furthermore, even if you are an existing Fidelity customer, always choosing an iShares product over other ETF offerings is likely not as clear-cut as it appears.

Commissions are but one component of total costs. Liquidity is also an important factor because more widely traded funds tend to have tighter bid/ask spreads and to trade closer to net asset value than competing products. In this regard, iShares funds tend to be some of the most liquid funds available. The other major component of total costs is the management fee of the fund.

Like commissions, all-in management fees on most cap-weighted equity-based index ETFs are easy to quantify. All else equal, choosing the fund with the lowest cost will translate into higher investor returns. Now that Fidelity and Schwab clients can trade some funds without commissions, but some similarly structured ETFs are available with lower management fees, which funds should they choose? Like most things in investing, the answer is, it depends.

For comparison's sake, we compiled a table listing most of the equity-based iShares funds that Fidelity investors can purchase commission-free and paired them with what we deem to be the most similar fund provided by Vanguard. In some cases, the two ETFs compared replicate the same index. In other cases, the funds compared have portfolios that are nearly identical. We chose Vanguard because of its multidecade record of keeping costs lower than the competition. In no way are we saying that other providers, most notably State Street Global Advisors via its SPDR lineup, do not have funds that would compare favorably with either of these providers in some instances. That said, check out the results.



Individual Investing Goals Weigh Heavily
All but one of the Vanguard funds that we compared with the iShares lineup is cheaper on a provider-fee basis, so potential investors must make some considerations to find the right fund. The most important considerations for choosing between the lower-cost fund or the commission-free option are the size of the investment and the frequency of transactions. For investors already on the Fidelity platform who will be making frequent smaller contributions to, or withdrawals from, their portfolios, the iShares lineup is probably the right choice. But if you plan on trading infrequently, perhaps only once a year, and have more than $10,000 to invest in any one of these funds, chances are that the Vanguard fund would be more appropriate for you even when commission charges are considered.

And, as the holding period increases in duration, management fees become much more important in comparison with commissions. Management fees will be charged every year, regardless of fund performance or number of transactions. Commissions are event-driven in that they are charged only when the investor takes action. If I were going to park $10,000 in an index fund based on the MSCI Emerging Markets Index, I could purchase iShares MSCI Emerging Markets Index EEM and save $16 in commissions--one fee to get in, one to get out. Or I could use Vanguard Emerging Markets Stock Index VWO and save $45 per year. Even if I were making quarterly contributions to either of these funds but had more than $10,000 in capital, I would choose VWO. Alternatively, I could park the majority of my capital in VWO and make regular contributions to EEM until I accumulate enough assets to warrant a transfer.

The possible combinations are endless, but the takeaway is that different funds will be right for different investors based on the funds' distinctive consequences. The other takeaway is that when fund companies and trading platform providers compete, investors win.

Paul Justice is an ETF strategist with Morningstar and a contributor to Morningstar's ETFInvestor newsletter.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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