Next to Nothing

Jonathan Clements

YOU CAN BUILD a great portfolio with just three index funds: a U.S. total stock market fund, an international fund that buys both developed and emerging stock markets, and a high-quality U.S. bond fund. Thanks to the ongoing price war among major index-fund providers, all three funds are now on offer at extraordinarily low annual expenses.

Below are some of the funds available, with their expenses listed in parentheses. These figures come from fund company websites or a fund’s latest annual report:

Total U.S. stock market funds. You can buy mutual funds such as Fidelity Total Market Index Premium Class (0.045%), Schwab Total Stock Market Index Fund (0.03%) and Vanguard Total Stock Market Index Admiral Shares (0.04%). Alternatively, you might purchase exchange-traded funds (ETFs) like iShares Core S&P Total U.S. Stock Market ETF (0.03%), Schwab U.S. Broad Market ETF (0.03%) and Vanguard Total Stock Market ETF (0.04%).

Total international stock funds. The mutual funds on offer include Fidelity Global ex U.S. Index Premium Class (0.11%) and Vanguard FTSE All-World ex-U.S. Index Admiral Shares (0.11%), while ETF buyers might consider iShares Core MSCI Total International Stock ETF (0.11%) and Vanguard FTSE All-World ex-U.S. ETF (0.11%).

Total U.S. bond market funds. Mutual fund buyers can invest in Fidelity U.S. Bond Index Premium Class (0.05%), Schwab U.S. Aggregate Bond Index Fund (0.04%) and Vanguard Total Bond Market Index Admiral Shares (0.05%). ETF investors should check out iShares Core U.S. Aggregate Bond ETF (0.05%), Schwab U.S. Aggregate Bond ETF (0.04%) and Vanguard Total Bond Market ETF (0.05%).

Suppose you were aiming to build a balanced portfolio, with 40% U.S. stocks, 20% foreign shares and 40% high-quality bonds. Using the lowest-cost funds listed above, your weighted average annual expenses would be 0.05%, whether you opted for mutual funds or ETFs. That’s just $50 a year on a $100,000 portfolio.

Because ETFs are listed on the stock market, buyers also incur trading costs, including bid-ask spreads and commissions. By contrast, the mutual funds are all no-load, so there’s no commissions to be paid. Because of trading costs, those who regularly add to their accounts should probably favor mutual funds, while those with a lump sum to invest might opt for ETFs, which could prove marginally more tax-efficient. Either way, the costs are amazingly low—especially compared to actively managed funds, which often charge 1% a year or more.

Keep four caveats in mind. First, to get the low expenses on the Fidelity and Vanguard mutual funds listed above, you need to invest $10,000 per fund. For smaller accounts, annual costs are somewhat higher.

Second, today’s price war is focused largely on flagship funds, such as those listed above. Many more specialized index funds remain relatively expensive.

Third, if you already own one of the funds above, it isn’t worth swapping into another fund with marginally lower expenses: You could incur trading costs and trigger a tax bill, and you might find yourself out of the market for a few days during the switch. On top of that, it could be that the slightly more expensive fund performs better, thanks to securities lending and smarter trading, plus it might be more tax-efficient.

Finally, fund companies could reverse their price cuts. That’s unlikely at Vanguard Group, which aims to operate each fund at cost. But other companies may be barely breaking even at current expense ratios and perhaps even losing money, so there’s a risk they’ll eventually opt to raise expenses.

It’s easy to imagine that happening in a bear market, when investors are no longer in a buying mood. At that juncture, fund companies might feel they can raise expenses with impunity, knowing there aren’t many new investment dollars to attract—and knowing that existing investors would be reluctant to sell, because of the tax bills and trading costs they’d face.

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