Research shows that low fees are the best predictor of ETF performance. This article examines that research and identifies the right ETFs to implement the concept, as well as identifying basic caveats.
Low fees are the best predictor of ETF performance
Last year, the NY Times reported that Morningstar research found that focusing on low cost ETFs in terms of fees as the best predictor of future ETF performance. Selecting the cheapest ETF was a better single rule than Morningstar's own star ratings.
This result makes intuitive sense, especially for ETFs that track broad, liquid indexes. Fees are the one thing about an ETF that can be known in advance with certainty and by definition have a 1 for 1 relationship with the value of the investment. All other aspects of the investment by comparison are more subjective and less directly correlated with performance.
Finding the cheapest ETFs by category
But with new ETFs launching all the time, which are the cheapest ETFs currently?
|US Equity||Focus Morningstar US Market ETF||FMU||0.05%||$12M|
|Aggregate Bond||Vanguard Total Bond Market Fund||BND||0.11%||$15B|
|TIPS||Schwab TIPS ETF||SCHP||0.12%||$300M|
|International Developed Equity||Vanguard Tax Managed International Fund||VEA||0.12%||$8B|
|International Emerging Equity||Vanguard Emerging Markets Stock Index Fund||VWO||0.22%||$48B|
Watch out for low market cap: It is perhaps unsurprising that Vanguard wins on fees in most categories, but it is interesting to note how aggressively some others, such as FocusShares and Schwab, are in competing on price in US equity and TIPS respectively. Nonetheless, there is a slight wrinkle as Devin Riley has noted. The first ETF to launch tends to get the most assets. Therefore, although Schwab and FocusShares are the cheapest in certain categories they have a much smaller market cap. Pay attention to the bid/ask spread for these ETFs to ensure the lower fees are not lost in the spread you pay to get in and out of the ETF.
Though focusing on low fees works for major indexes and asset classes, I would be cautious about extending that assertion to more sophisticated products like levered/directional ETFs or potentially illiquid asset sub-classes such as high yield debt.
If you're using ETFs to track a major index or asset class, keep an eye on the fees you're paying because you may be able to achieve a better investment performance simply by lowering your fees. In particular, the working assumption that Vanguard has the cheapest ETFs may be misleading for certain asset classes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.