There are more than 1,500 exchange-traded funds (ETFs) on the market in the United States, so narrowing your choices can be difficult. If you’re thinking about relying on certain rules of thumb for choosing ETFs—particularly those regarding ratings, operating expenses and commissions—you might want to reconsider.
Misconception 1: The best ETFs have high Morningstar ratings
Independent research firm Morningstar® is well known for its star ratings. Funds whose risk-adjusted performance has been strong relative to their category peers during the past three, five and 10 years generally receive four- or five-star ratings. Funds with weaker performance receive one- or two-star ratings.
Investors often gravitate toward funds with four and five stars, whether they’re looking at mutual funds or ETFs. But are more stars the sign of a good product?
Well, keep in mind how these star ratings are calculated. They’re based on past performance, with no regard for liquidity or other important factors. This means stars tell you only how a fund has performed in the past, not how it will do in the future.
Funds must have a track record of at least three years in order to get a rating at all. And even though most ETFs try to replicate the performance of some broad segment of the market by tracking an index, they’re ranked in a big group alongside mutual funds—most of which are actively managed in an attempt to outperform the market.
If you see an ETF with a high star rating, this usually means one of two things:
- Active mutual fund managers (who make up most of the peer group) have struggled to beat the market in this category, or
- The ETF tracks a narrow segment of the market that happens to have performed well recently.
It’s not uncommon to see ETFs with three-star ratings, meaning that they’ve performed around the middle of the pack. That’s actually what you’d expect for an index product in most market environments.
Bottom line: When it comes to ETFs, stars don’t matter.
Misconception #2: Operating expenses are everything
ETFs have a well-deserved reputation for low costs—particularly when it comes to operating expense ratios (OERs), which can be as low as 0.04% of your investment per year, although the typical ETF charges about 0.29%.1
Low operating expenses aren’t everything, though, especially if you’re planning to trade a fund regularly. Every time you place a trade, you have to account for the fund’s bid/ask spread, the price gap between what you’ll have to pay if you want to buy shares (the higher “ask” price) and what you would get if you wanted to sell shares at that same moment (the lower “bid” price). Depending on market liquidity, this spread may be small or it may be significant.
Commissions matter, too, especially if you’re investing only a few thousand dollars. If you plan to invest $1,000 in an ETF and have to choose between one with a $9 commission and one with no commission at all, picking the ETF with the $9 commission amounts to a trading expense totaling 0.90% of your investment. That cost erodes your investment return.
However, if you’re investing $100,000 or more, then the commission represents less than 0.01% of your investment, and probably isn’t worth losing sleep over.
Bottom line: There’s more to cost than just operating expenses.
Misconception #3: Always opt for the commission-free ETF
Yes, we just said that commissions matter, particularly for smaller investments. But if you plan to invest tens of thousands of dollars or more in an ETF, trading commissions aren’t the main driver of cost. The bid/ask spread and OER, meanwhile, continue to matter just as much.
Similarly, if you plan to hold an ETF for many years, transaction costs like commissions and bid/ask spreads matter less than the OER because that’s an expense you pay every year.
So don’t select a commission-free ETF for that reason alone. As with all investments, the right ETF is the one that best fits your portfolio. If you find an ETF that suits your needs but isn’t available commission-free, it still might be the best option.
Bottom line: Commission costs matter, but your ETF selection should be based on more considerations than commissions alone.
1. Asset-weighted average expense ratio. Source: Charles Schwab Investment Advisory, Inc., based on data from Morningstar Direct as of 6/30/2015.