The Price Is Slight

Jonathan Clements

I LOVE THE PRICE war among index-fund providers, because it puts pressure on all money managers to lower fees. But I don’t think investors should pay much heed to differences in annual expenses that amount to just 0.01% or 0.02% a year, equal to 1 or 2 cents for every $100 invested—and they certainly shouldn’t switch funds for those potential cost savings.

To check I wasn’t missing something, I set out to do apples-to-apples comparisons among index funds in four highly competitively segments of the indexing market: large-cap U.S. stocks, total U.S. stock market, total international stock market and total U.S. bond market. Everything else being equal, you’d expect the funds with the lowest costs to have the best performance.

But did they? Finding out was trickier than I expected. Like boxers trying to avoid fighting their toughest contenders, it seems index-fund providers almost deliberately opt to track different indexes, making it impossible to do a straight comparison.

That said, two indexes do see fierce head-to-head competition: the S&P 500 index of large-cap U.S. stocks and the Bloomberg Barclays U.S. Aggregate Bond Index of high-quality U.S. bonds. In the case of S&P 500 funds, four of the five cheapest funds fought to a draw in 2017, all posting exactly the same total return, despite tiny differences in annual expenses:

Fidelity 500 Index Fund Premium Class

  • Annual Expenses: 0.035%
  • 2017 Return: 21.79%

iShares Core S&P 500 ETF

  • Annual Expenses: 0.04%
  • 2017 Return: 21.79%

Schwab S&P 500 Index Fund

  • Annual Expenses: 0.03%
  • 2017 Return: 21.79%

Vanguard 500 Index Fund Admiral Shares

  • Annual Expenses: 0.04%
  • 2017 Return: 21.79%

Vanguard S&P 500 ETF

  • Annual Expenses: 0.04%
  • 2017 Return: 21.78%

S&P 500’s 2017 Total Return: 21.83%

The iShares fund and one of the two Vanguard Group offerings are exchange-traded funds, or ETFs, so investors need to buy the stock market-listed shares. By contrast, the other three funds are mutual funds, meaning you purchase shares directly from the fund company involved. An ETF’s share price performance can vary slightly from the performance of its underlying portfolio. Still, the results shown above are the total return for the underlying portfolio, because the goal here is to look at the impact of expenses on performance, plus it allows for a clean comparison between competing ETFs and mutual funds.

It’s no great surprise that the 2017 results for four of the five S&P 500 funds turned out to be exactly the same: Not only do the funds have very similar expenses, but also they’re replicating an index fund that contains just 500 stocks. By contrast, the Bloomberg Barclays U.S. Aggregate Bond Index is a tougher benchmark to track, because it contains almost 10,000 different issues. With such broad indexes, funds are more likely to use sampling techniques, rather than buying every security, so there’s a greater chance of tracking error. Sure enough, results for three of the lowest-cost funds differed somewhat—and expenses weren’t the deciding factor:

Fidelity U.S. Bond Index Premium Class

  • Annual Expenses: 0.045%
  • 2017 Return: 3.47%

iShares Core U.S. Aggregate Bond ETF

  • Annual Expenses: 0.05%
  • 2017 Return: 3.53%

Schwab U.S. Aggregate Bond ETF

  • Annual Expenses: 0.04%
  • 2017 Return: 3.46%

Bloomberg Barclays U.S. Aggregate’s 2017 Total Return: 3.54%

Vanguard has both a mutual fund and an ETF that also tracks the Bloomberg Barclays U.S. Aggregate Bond Index, but they track a “free float” version of the index that gives less weight to a bond if part of the issue isn’t available to trade. In 2017, the free float index fared slightly better, and thus so too did Vanguard’s funds.

What about total U.S. stock market index funds and total international stock index funds? These funds—like total bond market funds—track indexes with thousands of securities, so there’s more chance for slippage.

Among the lowest-cost funds, you usually can’t see this slippage by comparing one with another, because they almost all track different indexes. What to do? I looked at how each fund’s total return compared to its own benchmark index.

You would expect funds to trail their benchmark by the amount of their annual expenses. But often, performance relative to the index bore little relationship to fund expenses. For instance, as you’ll see below, Schwab’s Total Stock Market Index Fund—a mutual fund—lagged behind its index by 0.1% in 2017, despite being one of the category’s cheapest funds, with expenses of 0.03% a year.

Meanwhile, iShares’s international fund outperformed by 0.27%, a surprisingly large margin. Indeed, the margin of outperformance would have been 0.38% if we add back the fund’s 0.11% annual expenses. That index-beating gain was a nice bonus for the fund’s shareholders. But it isn’t clear whether this outperformance resulted from skillful trade execution by the fund’s managers and gains from securities lending, or whether it was due to some lucky break, perhaps resulting from the sample of stocks bought or the timing of share purchases.

An added complication: In all four categories we’re analyzing here, Vanguard has both ETFs and so-called Admiral Shares, which is its lowest-cost mutual fund share class. In every case, there was a slight performance difference between the ETF and the mutual fund. To simplify things, I’ve listed only Vanguard’s ETFs below.

Fidelity Global ex U.S. Index Premium Class

  • Annual Expenses: 0.1%
  • Fund vs. Index: -0.05%

Fidelity Total Market Index Premium Class

  • Annual Expenses: 0.035%
  • Fund vs. Index: -0.01%

iShares Core MSCI Total International Stock ETF

  • Annual Expenses: 0.11%
  • Fund vs. Index: +0.27%

iShares Core S&P Total U.S. Stock Market ETF

  • Annual Expenses: 0.03%
  • Fund vs. Index: +0.07%

Schwab Total Stock Market Index Fund

  • Annual Expenses: 0.03%
  • Fund vs. Index: -0.1%

Schwab U.S. Broad Market ETF

  • Annual Expenses: 0.03%
  • Fund vs. Index: -0.02%

Vanguard FTSE All-World ex-U.S. ETF

  • Annual Expenses: 0.11%
  • Fund vs. Index: +0.13%

Vanguard Total International Stock ETF

  • Annual Expenses: 0.11%
  • Fund vs. Index: +0.11%

Vanguard Total Stock Market ETF

  • Annual Expenses: 0.04%
  • Fund vs. Index: -0.03%

What’s the lesson here? If you’re paying 1% a year, it’s a huge win to swap to a fund charging 0.1% or less. But once you’ve narrowed your shopping list to funds with that sort of cost, you should probably focus less on differences in annual expenses and instead pay attention to other issues.

Questions you might ask: Does a funds buy most or all of the securities in the underlying index, so there’s less risk of tracking error? When comparing funds, what are the differences in the underlying indexes, such as the array of countries included or the market capitalization of the typical stock bought? If you’re buying a mutual fund, does the fund company offer other funds or services you find appealing? If you’re purchasing an ETF, can you buy shares commission-free and how wide is the typical bid-ask spread—the gap between the price at which you can currently sell and the higher price at which you can buy? If you’re buying through a taxable account, has the fund triggered tax bills for shareholders by making capital-gains distributions in recent years?

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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