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Almost Zero

Jonathan Clements  |  July 25, 2020

IT’S NEVER BEEN cheaper to build a globally diversified portfolio of index funds. In fact, today, you could invest $100,000 and pay just $10 in annual fund expenses—equal to the cost of two Big Macs and a large fries.

Moreover, you don’t need $100,000 to build that portfolio. Not even close. The funds in question—which are managed by Fidelity Investments—have no required investment minimum, which means your four-year-old could start investing with the contents of her piggybank. How’s that for a Happy Meal?

The fee-cutting war among index funds no longer garners headlines. Nonetheless, it grinds on, with small expense cuts here and there. To see the impact, I calculated the annual cost of owning a balanced portfolio consisting of 40% high-quality U.S. bonds and 60% stocks, with the stocks divided equally between U.S. and foreign shares.

I realize most folks aren’t comfortable putting that much in foreign markets, but that is—roughly speaking—how the global stock market is divvied up today and, indeed, that’s how I invest my own money. Below are six possible investment mixes built using funds from five major providers of index mutual funds and exchange-traded index funds (ETFs). Each fund’s annual expense ratio is listed in parentheses.

1. Fidelity Investments

2. iShares

3. Charles Schwab

4. SPDR

5. Vanguard Group

6. Vanguard Group

You’ll notice that the portfolio built with State Street’s SPDR ETFs, and one of the Vanguard Group portfolios, includes a world stock index fund, which means you’re getting U.S. and foreign shares in a single package. I’m intrigued by these funds, because—by wrapping together all stocks in one fund—you’re less likely to have behavioral problems, where investors start second-guessing how much they have in U.S. stocks and how much abroad. The downside is that the world stock index fund category isn’t as competitive, so annual fund expenses are a tad higher.

Indeed, one reason the above portfolios have such low costs is because we’re looking at the most competitive part of the fund market. Vanguard’s declared goal is to operate its funds at cost, which means that—for the other fund companies—the funds listed here are either breakeven propositions or loss leaders, with Fidelity presumably taking the biggest hit.

As you’ll have no doubt noticed, the Fidelity portfolio is far cheaper than its competitors. It costs just $10 per $100,000, versus $46.50 for the Schwab portfolio, which is the next cheapest. Moreover, the Fidelity portfolio consists of index mutual funds. That means you buy and sell directly from Fidelity as of the 4 pm ET market close, and your trades take place at each fund’s per-share portfolio value, otherwise known as the “net asset value.” By contrast, the other five portfolios consist of ETFs. Because ETFs are listed on the stock market, every time you buy and sell you lose a little to the bid-ask spread, an added cost you don’t incur with mutual fund trades.

Does all this mean that Fidelity should be the first choice of every cost-conscious index fund investor? We’re talking about saving perhaps $40 a year on a $100,000 portfolio—and I readily concede there are many things I would do to save $40. That said, before you move all your money to Fidelity, or to any other firm’s funds, here are five other issues to consider:

1. Capital gains taxes. If you’re sitting with a collection of index funds in a taxable account and there are lower-cost alternatives, it simply isn’t worth changing investments if the move will trigger capital gains taxes. What if you’re dealing with an IRA? Swapping investments within an IRA won’t trigger any tax bill. Still, you could get hit with a fee if you move your IRA from one financial firm to another. Schwab, for instance, charges as much as $50 to transfer an account to another firm.

2. Tracking error. Over the 12 months through June 30, Fidelity ZERO International Index Fund beat its benchmark index by 0.18 percentage point, iShares Core MSCI Total International Stock ETF by 0.09 and Vanguard Total International Stock ETF by 0.37. A cause for celebration? I don’t think so. There’s every chance such tracking error could hurt rather than help.

For instance, the SPDR Portfolio Aggregate Bond ETF fell behind its benchmark by 0.21 percentage point over the past year. That sort of tracking error can easily swamp any tiny advantage you might gain by swapping to a lower-cost fund. My advice: Check how a fund’s net asset value performance (and not its market performance, assuming you’re looking at an ETF) compares to its benchmark index. Think twice before buying a fund that struggles to mirror its benchmark, especially if those struggles are evident over multiple years.

3. Sweep accounts. The flagship index funds listed above are making little or no money for Fidelity, iShares, Schwab and SPDR, which means they’re hoping to compensate by also selling you other products.  If you buy those other products, they’ll often be more expensive than what’s on offer at Vanguard, though not always.

If you stick with the low-cost offerings listed above, that won’t matter. But if these index funds above are just one part of your portfolio, it’s a bigger issue. For instance, if you not only opt for Fidelity or Schwab’s flagship index funds, but also choose to use their brokerage platform, pay attention to the yield on their sweep account—the place where money sits between trades.

For its sweep account, Vanguard uses a government money market fund that was recently yielding 0.1%. Fidelity also uses a government money market fund, but it only yields 0.01%, while Schwab parks customers’ cash at its banking affiliate, where the money was recently earning the same 0.01%. The yield difference among these sweep accounts was even larger before the Federal Reserve slashed short-term interest rates. (In case you’re wondering, iShares and SPDR don’t have retail brokerage operations like Fidelity, Schwab and Vanguard, so you’ll want to set up a brokerage account elsewhere to buy their funds.)

4. Customer service. We’re now firmly in the land of anecdotal evidence, a place I try to avoid. Still, I hear and read people raving about customer service at Fidelity and Schwab, while Vanguard’s service seems to prompt more grumbling.

5. Bait and switch. When the index fund fee-cutting war broke out a few years ago, I worried that Vanguard’s competitors would use the low fees to attract new investors and then later jack up expenses, milking profits from the assets they’d gathered. Yes, it’s happened before.

Today, I no longer think this is a serious risk. Because the competitive pressures are so great and the potential damage to their reputation so devastating, fund companies—I believe—would be profoundly reluctant to reverse their fee cuts. But if you’re worried about that possibility, stick with Vanguard.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include My Four Goals15 Ways to Happy and Sunny Prospects.

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