ETFs and Falling Fund Fees

As I frequently note in my Champion Funds newsletter service, the number to watch for fund investors is the expense ratio -- and that's particularly true for index fund investors. Why pay any more than the bare minimum, after all, for a pick that merely tracks a benchmark?

Consequently, whenever news breaks from the wonderful world of index funds, it usually has to do with price tags. Earlier this year, Fidelity -- the Boston-based money manager and one of the fund industry's true 900-pound gorillas -- slashed prices at several of its leading index funds, Fidelity Spartan 500 Index (FUND:FSMKX) included.

Spartan 500 -- which counts the likes of Microsoft (NASDAQ:MSFT), ExxonMobil (NYSE:XOM), Pfizer (NYSE:PFE), and Citigroup (NYSE:C) among its top 10 holdings -- boasts an enormous asset base of roughly $10.5 billion, and along with Fido funds that track indexes such as the Wilshire 4500, the Wilshire 5000, and the MSCI EAFE (a proxy for the broader international market), it now goes for a measly 10 basis points.

This is welcome news for index investors, but not so great for Vanguard, the huge mutual fund complex that has long been the king of the indexing hill. Because profit margins on index funds are paper thin, it's largely a volume business. And if Fidelity's price cuts succeed in attracting assets that would otherwise have gone to Vanguard, the fees those monies generate will further fatten Fidelity's bulging coffers and not those of the house that Jack Bogle built.

ETF fever: Have you caught it?
The Vanguard/Fidelity rivalry, however, is hardly the only source of intrigue here: Fidelity's move is also no doubt meant as a kind of rear-guard action against the growing threat of exchange-traded funds (ETFs). The expansion in this area has been astronomical in recent years, with the Investment Company Institute, the fund industry's lobbying arm, reporting an increase of more than 160% in assets under management in ETFs since 2000. Low costs are the main appeal of ETFs, which track indexes like plain-vanilla funds but trade throughout the day like stocks. They typically run with expense ratios significantly below those of comparable mutual funds.

At least, that is, until now. Spiders (AMEX:SPY), the popular Standard & Poor's ETF, now costs more than Spartan 500, and while it's true that iShares S&P 500 Index (AMEX:IVV) sports an expense ratio of 0.09%, its one-basis-point advantage isn't enough to offset the main drawback of all ETFs: Their price tags are cheaper, sure. But because they trade like stocks, you'll have to pony up a brokerage fee every time you buy and sell them. For dollar-cost averagers, then, ETFs don't make a whole lot of sense.

Use as directed
Don't get me wrong: Provided they're used intelligently -- and there are plenty of ways to do just that -- I'm actually a big fan of ETFs. Indeed, in the next issue of Champion Funds, I highlight a suite of just-off-the-assembly-line ETFs that may be just what the doctor ordered for many a jaded fund investor.

Still, the hype in the financial media has far outrun the reality about ETFs. Moreover, as savvy investors know, owning both index funds and actively managed picks is just another layer of intelligent asset allocation.

What, exactly, do I mean by that? Just this: During certain market periods -- the last five years, say -- actively managed funds fare best, while at other times (the late 1990s, for instance), indexing leads the way. The upshot (as I never tire of pointing out) is that there's no need to try to guess whose turn it is if you don't have to.

There's also no need to pay any more than you have to for funds that merely track indexes. And now, thanks in large part to ETFs and the price pressure they've brought to bear, that portion of your portfolio can be significantly lighter on your pocketbook.

Interested in ETFs? Make a quick visit to the Fool's new ETF Center today.