If you invested in two ETFs that purported to own the same investments, you'd probably expect to get pretty much identical returns. But smart investors can often eke out a bit of extra return by doing something extremely simple: going with the ETF with the lower fee.
The benefits of ETFs
Exchange-traded funds have simplified investing for millions of investors. Rather than turning over decision-making authority for their investments to active mutual fund managers who have free rein to pick just about any stocks they want, ETFs reduce investing to simple, methodical, index-driven strategies that remove any ability for fund managers to mess up. And because ETFs make their holdings known every day, you can easily detect if your ETF's managers do something they're not supposed to do.
With the fast proliferation of ETFs, you'll find lots of duplication among ETFs that have the same stated investing strategy. For instance, just about every ETF provider has an ETF geared toward those who want to invest in large-cap U.S. stocks. Often, you won't be able to find any way to tell two ETFs apart -- at least until you look at how much they charge as management fees.
Why pay more?
It's odd just how many pricing disparities you can find once you start looking. Even among some of the biggest, best-known ETFs, shareholders are willing to pay more for exactly the same thing. You'd think it was like buying name-brand pretzels instead of the store brand -- that the more expensive ETFs somehow "taste" better than lower-priced "generic" ETFs.
With pretzels, I'd be willing to concede the point -- I've paid up for my favorite brand more than once. But with ETFs, high fees can leave a bad taste in your mouth.
Look at iShares MSCI Emerging Markets (NYSE: EEM ) . It charges an annual expense ratio of 0.69%. It has also performed very well recently, with 10.8% average annual returns over the past five years.
But when you turn to competing Vanguard MSCI Emerging Markets (NYSE: VWO ) , you'll see that the iShares fund wasn't all it was cracked up to be. Vanguard's emerging-market ETF has a return of 11.8% over that same period -- with fees of just 0.22%.
You can find the same story with several other pairs of ETFs:
- SPDR Gold Trust (NYSE: GLD ) is the most popular gold bullion ETF, with around $60 billion under management. Yet its 0.40% expense ratio doesn't compare well with iShares Comex Gold (NYSE: IAU ) and its 0.25% cost – and, as you'd expect, the iShares fund is up 26.2% versus the SPDR's 26% over the past year.
- Sometimes, the differences are more striking. iShares Russell 2000 ETF has ridden the crest of small-cap interest to rise 24.8% annually over the past two years and 6.4% since 2004. But Vanguard Small-Cap ETF (NYSE: VB ) has done far better, with an average return of 28% since 2009 and 7.7% over the past seven years.
From that last example, it's clear that the differences between funds aren't always due solely to cost. The iShares small-cap ETF's expense ratio of 0.28% isn't that much higher than Vanguard's 0.17%. Sometimes, subtle distinctions in the way ETFs execute their strategies can lead to tracking error and much larger variations in returns than you'd expect just from looking at expenses.
But it's clear that premium pricing comes at a cost. Last year, iShares owner BlackRock (NYSE: BLK ) got downgraded because of concerns over pricing pressure from Vanguard and Charles Schwab (NYSE: SCHW ) .
Keep your money
Of course, sometimes, there are reasons to pay up. For instance, if your broker gives you special access to ETFs from a certain provider, as Fidelity does for iShares ETFs, then the cost savings from paying no commissions on purchases and sales may offset the higher annual cost.
For most people, though, the final question is this: Do you want to give your money to your ETF provider or keep it for yourself? To hold onto your hard-earned cash, don't pay more than you have to for ETFs. That'll give you a lot more crunch in your portfolio.
Want some ideas about smart low-cost ETF prospects? Click here to read The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."