What it means
Every ETF has costs. The best-known is the expense ratio, which is the annual percentage of your investment taken to run the fund.
A few funds have been launched with an expense ratio of zero, usually as a way for the provider to attract investors and sell other services. The other common meaning is commission-free trading.
Many brokers let customers buy and sell selected ETFs without paying a trading commission. In that case the fund itself still charges its normal expense ratio, but the cost of placing the trade disappears.
Zero does not mean free in every sense. Investors can still face the bid-ask spread (the small gap between the price to buy and the price to sell), tracking differences between the fund and its index, and taxes on gains or distributions.
A fund with no headline fee can also be priced less well than a low-fee rival if its trading is thin. The provider has to earn money somewhere.
It may lend out the fund's holdings to short sellers and keep part of the income, cross-sell other products, or run the fund at a loss to build market share. Investors should ask why the fee is zero and whether the offer is permanent, because fee waivers can be temporary.
For a manager choosing a fund for company reserves or a staff pension, the sensible approach is to compare total cost of ownership. That includes the expense ratio, trading costs, the spread and the quality of the index tracked.
A cheap fund that follows a poor index is still a poor investment. Finally, a zero fee may encourage investors to hold more of one fund than is wise.
Diversification still matters, because a single fund concentrated in one market or sector carries risk whatever it costs. A sensible portfolio decision starts with what you want to own and only then looks at the price.
In practice
Real-world examples.
Example
A small business invests $50,000 of surplus cash in a broad share-index ETF with a zero expense ratio. The fund saves roughly $100 a year compared with a fund charging 0.20%. The finance manager also checks the spread and finds it is only a few cents per share.
Example
A young employee buys $200 of a popular ETF each month through an app that charges no commissions. Without the app's offer, a $5 commission on every trade would equal 2.5% of each purchase. The fund's own expense ratio of 0.05% still applies.
Example
A retiree considers a zero-fee ETF from a new provider. He learns the waiver lasts for only the first two years and then rises to 0.15%. He decides to compare it with established low-cost funds before committing.
Formula
Calculation
Annual fund cost = amount invested x expense ratio
An investor puts $100,000 into an ETF with an expense ratio of 0.20% and compares it with a no-fee ETF with an expense ratio of 0%. Annual cost of the first fund = 100,000 x 0.0020 = $200, while the no-fee fund costs $0. Over ten years, ignoring growth, the saving is 200 x 10 = $2,000.Case study
Seen in the real world.
Northgate Asset Management is a fictional fund provider that launched a zero-fee ETF tracking a large-company index. In this illustrative story, the firm hoped to attract $2 billion of assets and sell investors its paid advisory service. Within a year the fund held $1.4 billion, and about 12% of its investors had opened paid accounts.
Not every investor was pleased. One company treasurer found that the fund's trading volume was low on volatile days, so the spread was wider than that of a competing fund with a 0.03% fee. The treasurer concluded that the saving of 0.03% was smaller than the extra cost of trading, and switched back. The company has since adopted a policy of comparing funds by total cost, index quality and liquidity, and it reviews that comparison once a year.
Watch out
Common mistakes.
- Assuming a no-fee ETF has no costs at all. Spreads, tracking error and taxes still apply.
- Confusing commission-free trading with a zero expense ratio. In the first case you pay no trading charge, but the fund still deducts its annual fee.
- Choosing a fund on fee alone. The quality of the index, the size of the fund and how easily it trades matter as well.
Questions
People also ask.
How can a provider afford to run a fund for nothing?
It may earn income from securities lending, from selling other products to the same investors, or it may accept a loss to gain market share.
Is the zero fee permanent?
Not necessarily, so read the fund's documents to see whether the waiver has an end date.
What should I compare instead?
Compare the total cost of ownership, including the expense ratio, the bid-ask spread, trading charges and tax treatment.
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