Price Still Slight

Jonathan Clements

DO THE CHEAPEST index funds always win? A year ago, I tackled that question—and the results for 2017 were mixed. Since then, the question has become even more intriguing. Last year, Fidelity Investments launched four index-mutual funds with zero annual expenses, while also slashing the expenses on its existing index funds.

Those zero-cost funds have only been around for a handful of months, so it’s a little early to gauge their performance. Ditto for the price cuts for other Fidelity index funds; They were only in effect for last year’s final five months and hence you don’t see the full benefit when you look at 2018’s results. Some other index-fund managers also trimmed their expense ratios last year, though none as dramatically as Fidelity. Still, I figured I’d check back and see how important costs were in driving differences in index-fund performance over the past 12 months. As with last year, I looked at both index-mutual funds and exchange-traded index funds (ETFs).

You might imagine that annual fund expenses should be your sole selection criteria when picking among competing index funds. And, indeed, if you swap from an S&P 500 fund like T. Rowe Price Equity Index 500 Fund, which charges 0.21% in annual expenses, to Schwab S&P 500 Index Fund, which levies a mere 0.02%, you’ll almost certainly get better results. Sure enough, in 2018, the Schwab fund outperformed by 0.16 percentage point.

But what happens when fund expenses vary by just 0.01% or 0.02%, equal to 1 or 2 cents a year for every $100 invested? Do such tiny differences in expenses still determine which funds fare better? I looked at four major index-fund categories: total U.S. bond market funds, S&P 500-stock index funds, total U.S. stock market index funds and total international stock index funds (those that own both developed foreign markets and emerging markets).

Here’s how five of the cheapest S&P 500 funds fared in 2018:

Fidelity 500 Index Fund

  • Annual Expenses: 0.015%
  • 2018 Return: -4.40%

iShares Core S&P 500 ETF

  • Annual Expenses: 0.04%
  • 2018 Return: -4.42%

Schwab S&P 500 Index Fund

  • Annual Expenses: 0.02%
  • 2018 Return: -4.42%

Vanguard 500 Index Fund Admiral Shares

  • Annual Expenses: 0.04%
  • 2018 Return: -4.43%

Vanguard S&P 500 ETF

  • Annual Expenses: 0.04%
  • 2018 Return: -4.42%

S&P 500’s 2018 Total Return: -4.38%

It seems Fidelity’s low expense ratio has indeed given it a slight edge, but Schwab’s cost advantage hasn’t. The S&P 500 is a relatively easy index to track, because it includes just 500 stocks. The Bloomberg Barclays U.S. Aggregate Bond Index is much tougher: It contains some 10,000 bonds, so funds buy a sampling of the index’s bonds and hope that sample matches the index. Here’s the 2018 performance for four of the cheapest funds that track the Bloomberg Barclays index:

Fidelity U.S. Bond Index Fund

  • Annual Expenses: 0.025%
  • 2018 Return: +0.03%

iShares Core U.S. Aggregate Bond ETF

  • Annual Expenses: 0.05%
  • 2018 Return: -0.05%

Schwab U.S. Aggregate Bond ETF

  • Annual Expenses: 0.04%
  • 2018 Return: -0.09%

Schwab U.S. Aggregate Bond Index Fund

  • Annual Expenses: 0.04%
  • 2018 Return: -0.12%

Bloomberg Barclays U.S. Aggregate’s 2018 Total Return: +0.01%

Again, Fidelity’s cost advantage seems to have helped. But given that its fund outpaced the index, even after costs, presumably it also benefited from the sample of bonds it held. Schwab’s two funds, by contrast, fell behind the index by even more than their annual expenses.

Vanguard has both a mutual fund and an ETF that track 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. Both funds fared slightly better than their benchmark index, despite the drag from their 0.05% expense ratios. When it comes to Vanguard’s ETF, as well as other ETFs listed here, we’re looking at the performance of the fund’s portfolio relative to its benchmark index—which is what the manager controls—and not at the ETF’s share-price performance, which can be slightly different.

In our final head-to-head competition, here are two low-cost funds that track the Dow Jones U.S. Total  Stock Market Index:

Fidelity Total Market Index Fund

  • Annual Expenses: 0.015%
  • 2018 Return: -5.28%

Schwab Total Stock Market Index Fund

  • Annual Expenses: 0.03%
  • 2018 Return: -5.30%

Dow Jones U.S. Total  Stock Market Index’s 2018 Total Return: -5.30%

Once again, Fidelity’s marginally lower expenses appear to have given it an edge. What about other low-cost total U.S. stock market index funds, as well as low-cost total international stock index funds? These others funds all track different indexes.

What to do? To gauge how important expenses are, I looked at how each fund fared against its benchmark index. You would expect a fund to lag its index by an amount equal to the expenses it charges. But that was never the case—and, in fact, all the funds listed below outperformed their benchmark:

Fidelity Global ex U.S. Index Fund

  • Annual Expenses: 0.06%
  • Fund vs. Index: +0.13%

iShares Core MSCI Total International Stock ETF

  • Annual Expenses: 0.10%
  • Fund vs. Index: +0.21%

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

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

Schwab U.S. Broad Market ETF

  • Annual Expenses: 0.03%
  • Fund vs. Index: +0.01%

SPDR Portfolio Total Stock Market ETF

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

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

  • Annual Expenses: 0.11%
  • Fund vs. Index: +0.16%

Vanguard Total International Stock ETF

  • Annual Expenses: 0.11%
  • Fund vs. Index: +0.19%

Vanguard Total Stock Market ETF

  • Annual Expenses: 0.04%
  • Fund vs. Index: +0.04%

The above three Vanguard ETFs also have companion index mutual funds. The Admiral shares of the mutual-fund versions, which now have $3,000 minimums, either matched their benchmark index or outperformed it.

Why didn’t the above total U.S. market and total international funds all trail their benchmark by the amount of their costs? Because the funds don’t own all the stocks in the underlying index, they may have got lucky with their sampling. On top of that, index funds often lend out the securities they own to money managers, who then sell short the borrowed shares in a bet that their price will fall. In returns for lending securities, index funds earn interest that’s often passed along to fund shareholders—thereby helping to offset the drag from fund expenses.

The bottom line: Tiny differences in fund expenses do appear to make a difference in performance, especially when dealing with indexes that include relatively few securities, like the S&P 500. But once you stray into more exotic territory, other factors come into play, though I’d still expect the funds with the lowest costs to win out over the long haul. Does that mean it’s worth paying attention to 0.01% or 0.02% differences in fund expenses? Arguably, it is. Let’s say you invested $100,000 and earned 6.02% a year, rather than 6%. After 20 years, you’d have $1,212 more. That’s nothing to sniff at.

But before you starting shifting your portfolio to funds with lower annual expenses, ask yourself three questions:

  • Can you get all the low-cost funds you want, while still keeping your money at one brokerage firm or one mutual fund company? In the name of simplicity, I prefer to deal with just one investment firm—and I strongly suspect the executor of my estate will feel the same way.
  • What will your total annual cost be at your chosen investment firm? You don’t want to move to a new firm to get one or two super-cheap funds, only to find you’re paying more overall, because the firm’s other funds and services are a tad expensive.
  • If you decide to change investment firms, what’s the price to change—and is that price worth paying? If you have to sell existing index funds in a taxable account and that’ll trigger a large capital-gains tax bill, the answer is almost certainly “no.”

Follow Jonathan on Twitter @ClementsMoney and on FacebookHis most recent articles include Choosing Our FutureSaint Jack and Nursing Dollars. Jonathan’s latest book: From Here to Financial Happiness.

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