More Free ETFs Aren't Always Better

Exchange-traded funds have taken the investing world by storm, and even after the brief swoon in the stock market over the past couple of months, investors remain devoted to using ETFs as an easy and efficient way to invest their money. But as brokerage companies look for ways to capitalize on the ETF craze, some of the moves they're making don't always put investors first.

Back in March, brokerage and mutual-fund giant Fidelity announced that it had expanded its lineup of commission-free ETFs, continuing its partnership with iShares manager BlackRock (NYSE: BLK  ) to offer 65 ETFs. At the time, the move seemed to be a big positive for investors, broadening the array of available investment options beyond the previous selection of largely domestic-stock-focused funds. In particular, more than two dozen bond ETFs, a handful of commodity-oriented funds, and some new international stock funds rounded out the Fidelity ETF menu quite well.

Yet some of the trade-offs that Fidelity made in expanding its lineup have proven more problematic. Let's take a look at a couple of issues that should raise concerns.

1. Large bid-ask spreads
Commissions are only one part of the cost of trading ETFs. Another factor is the bid-ask spread, which measures the distance between what buyers are willing to pay you for your shares and what sellers are willing to accept to let you buy them. For frequent traders, bid-ask spreads are one of the most important aspects of an ETF, but even long-term investors have to deal with the bid-ask spread every time they make a new investment.

Many of Fidelity's core offerings have extremely low bid-ask spreads of just a penny per share. But especially among funds where iShares replaced former offerings with similar new funds, bid-ask spreads are uncomfortably high in some cases. For instance, the iShares Core MSCI EAFE ETF has a much lower expense ratio of 0.14% than the 0.34% of the $41 billion iShares MSCI EAFE ETF (NYSEMKT: EFA  ) , but the newly commission-free fund has an average bid-ask spread of 0.1%, equating to a typical spread of more than a nickel per share. You'll find a similar phenomenon comparing the iShares Core MSCI Emerging Markets ETF with the iShares MSCI Emerging Markets ETF (NYSEMKT: EEM  ) , with lower costs for the former offsetting greater liquidity for the latter. The tiny iShares MSCI Emerging Markets Small-Cap ETF has the highest average bid-ask spread of the lot, at a whopping 1.5%. With a dozen funds sporting bid-ask spreads of more than a quarter-percent, you'll pay a high price for the lack of liquidity in some of the funds iShares and Fidelity have made available.

2. Expense ratios
Another key component of ETF cost is the expense ratio. For the most part, Fidelity did a good job of giving investors inexpensive choices to select from, with 25 of its free ETFs having expense ratios of 0.2% or less. But not all of the broker's options are so thrifty.

In particular, expanding the menu to include more international stock ETFs and niche bond funds necessitated bringing in some higher-expense-ratio offerings into the mix. More than a dozen of the ETFs charge half a percent or more in annual fees, representing a fairly substantial departure from the relatively low-cost alternatives that were among the previous menu of commission-free ETFs.

Look beyond the numbers
Brokerage companies have made much of their commission-free ETF offerings, touting rising numbers of funds eligible for free trading. But those deals are only as good as the quality of the funds available. When ETF companies make strategic decisions that result in bolstering assets among less liquid fund offerings rather than giving customers access to the best products available, you need to be aware of what's going on -- and consider the impact on your results from using those ETFs in your portfolio.

ETFs can be great ways to make money. We've found three that you really should look at, and you can read all about them in the Fool's latest special free report on highly promising ETFs. Just click here to access it now.


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