Just how low can you go?

On September 26, 2019, Interactive Brokers began to offer zero-commission stock and ETF  (exchange-traded fund) trading via its Interactive Brokers Lite service. 

Not to be outdone, on October 8, 2019, Charles Schwab followed suit and announced zero fees. 

Just days later, rivals TD Ameritrade, E-Trade, Ally Invest, and Fidelity all announced zero-commision stock and ETF trading.

Of course, Robinhood has offered commission-free trades for years, but the moves from the large brokerages were a shock to the industry—and most certainly not a publicity stunt. 

All of these moves were good news for investors, as the costs to invest and create portfolios essentially dropped to zero. The drop in fees also encouraged those unfamiliar with trading and investment vehicles to give them a try—and having more participants both supports and drives the overall market.

Expense ratios jumping on the bandwagon

If zero-commission trades are a way to attract and retain brokerage customers, then why not lower other products, such as expense ratios for mutual funds?

An expense ratio is the amount that an investment company charges to manage the assets in an investment portfolio, a mutual fund, or ETF. The charges include costs related to management, administration, marketing, distribution, and operations, and it is calculated by dividing the fund's operating expenses by the average total dollar value of all the assets in the fund.

Conveniently, the expense ratio is calculated annually and is removed from the fund's earnings before they're distributed to investors. While the expense ratio directly reduces investors' returns, it is not a separate transaction or fee that investors must pay to stay active in the fund.

It’s worth noting that while brokerages might charge $0 to purchase shares of a mutual fund or ETF, the fund itself incorporates this extra fee to manage the fund. Investors are encouraged to always read the prospectus before investing.

A number of factors determine whether an expense ratio is high or low. In general, the more actively managed the fund, the higher the expenses and thus, the expense ratio is higher. 

Conversely, the more passively managed the fund is, the lower the ratio.

Examples of funds that require more active management include small-cap funds and international funds, as their assets might be traded less frequently and cost more for the portfolio manager to acquire.

Additionally, the size of the fund can affect the expense ratio. A fund with a smaller amount of assets usually has a higher expense ratio due to its limited fund base that must cover the same costs that are likely incurred by a larger fund focusing on the same asset classes.

A “good” expense ratio

Passively managed funds hold assets that mirror the components—and returns—of an index, such as the S&P 500. As such, changes to the asset mix rarely need to be made, and so less active management or oversight of the fund is required. This benefits investors: expenses on these types of funds are low.

The S&P 500 is a popular index on which to replicate a portfolio. The S&P 500 Index has experienced losses in only 10 of the 45 years spanning 1975 to 2019, according to Investopedia, demonstrating that over the long term, stocks that mirror broad sectors of the economy can deliver attractive returns to a portfolio. 

Investors generally do not need convincing about the strength of an index. From 1928 to 2016, the S&P 500 returned an average of 9.5% per year.  As a comparison, three-month Treasury bills return 3.5% and 10-year Treasury notes return 5%.

When the assets in a fund are constantly monitored, and adjusted to maximize the performance in a fund, investors pay more for this oversight. The costs to perform research and analysis, build models, and acquire thinly-traded securities in specialized sectors are incorporated in these expenses. Indeed, some investors eager to take advantage of these specialized funds are usually willing to pay higher fees because they understand the added complexity and difficulty in actively managing such funds.

According to Investopedia, a good expense ratio, from the investor's viewpoint, is around 0.5% to 0.75% for an actively managed portfolio. An expense ratio greater than 1.5% is considered high.

The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%. They rarely exceed 2.5%. For passive index funds, the typical ratio is about 0.2%.

Additionally, investors need to take into consideration these expenses when calculating total returns. If a fund realizes an overall annual return of 5% but charges expenses that total 2%, then the return is only 3% and 40% of the fund's return is wiped out fees.

Going even lower

In the continued race to the bottom, in late 2018, Fidelity launched its “zero-expense” ratio index mutual funds, with no account minimums. 

This was clearly a swipe against Vanguard, whose average mutual fund expense ratio is 0.10%. 

What might the future hold? Price wars actually pushed fund fees to below zero—for a while at least. In early 2019, startup ETF Salt Financial offered a negative-fee stock fund. Unfortunately, it didn’t make it—and we might blame Covid-19—Salt agreed to be acquired by Pacer Advisors, which removed the rebate, now charging 0.60% to investors.

Conclusion

For most small investors who lack the time to do the research and analysis and pick their own stocks, index investing is the way to go. Taking the long-term view and investing in a fund that mirrors the S&P 500, with costs of 10 to 15 basis points, is the most cost-effective way to take advantage of gains in the stock market while minimizing fees (or paying no fees at all).

Actively managed funds with high expense ratios are generally not for the risk-averse investor. However, they may yield a benefit that cannot be captured by broadly invested index funds, and so they justify higher fees.  

While transaction fees might be zero and management fees trending downward towards zero, investors need to examine prospectuses more closely to determine whether there are other minimums or requirements, which might possibly cut into investment returns.