Zero Fee Trades Likely Means Lower Fee ETFs - Part 2

Now that its clear investors understand how fees affect their returns and the financial industry as a whole is responding by lowering trading commissions to zero and cutting management fees on funds, its just a matter of time until we see ‘indexed’ funds begin to offer zero or near zero, as in 0.01% expense ratio, fee funds.

Why? Simple because they have to stay competitive if they want to stay in business.

For years the biggest argument for one someone would buy an index fund is because it would be so cumbersome and costly to go out and buy a few shares of all the different stocks that make up a specific index. For example, if an investor wanted to mimic the Dow Jones Industrial Average, they would need to go out and buy one share of each of the 30 companies that currently make up the index.

In the past, that would be 30 different stocks in someone’s personal portfolio, which honestly isn’t that much higher than what the average retail investor owns, typically somewhere between 15 and 20. However, that would also mean the investor would have paid a trading commission 30 different times in order to set up that portfolio (1 trading commission for each different company they bought a share or multiple shares of). If the average investor was paying $4.95 per trade, that’s $148.50 in trading commissions just so they could mimic the Dow Jones Industrial Average without having to pay a mutual fund or ETFs fees every year.

But now that trading commissions have been cut to zero, meaning an investor can buy 1 share of each of the Dow Jones Industrial Averages stocks for no cost, why would an investor pay even a 0.03% fee to an ETF, or even more like the 0.17% expense ratio the SPDR Dow Jones Industrial Average ETF (DIA) charges. One reason I can think of is because of a minor amount of convenience. Instead of placing 30 different trades, buying each of the 30 different stocks that make up the Dow Index, just make one trade and buy the Dow Index ETF. The other reason would be the total purchase cost. What I mean is that the DIA currently costs $270 per share, while one share of just Apple, one of the 30 Dow stocks, is going to cost an investor $248. So, the current cost of buying one share of each of the 30 Dow stocks would cost you just under $4,000.

Not only is it easier to make one purchase order and buy a few shares of the DIA ETF, but it's going to be a much lower initial investment for a retail investor. However, over the long run, a little upfront headache, buying each of the 30 Dow stocks, could save someone tens of thousands of dollars because they didn’t have to pay any fees.

A small investor with just a few thousand dollars invested may not see the value in building the Dow Index themselves, but those with large sums of money invested undoubtedly will.

Things obviously get much trickier when we start talking about the larger indexes such as the S&P 500 or the Russell 1,000 or 2,000. However, if investors show the willingness to go it alone and start ‘building’ these indexes themselves in their portfolios so too not pay the fees associated with the ETFs, the industry will be forced to play its hand and offer zero-fee ETFs, or at the very least substantially reduced fees to even what we see today.

I would bet that in the future, we will not only see 0.01% expense ratio ETFs but funds that are charging sub 0.01% expense ratios. Which at an expense ratio of less than 0.01%, there is value to the investor because of the headache and time it would consume to replicate the larger indexes. But at a price much higher than 0.01%, it's hard to justify paying that amount for something you can replicate on your own for zero cost, especially if you are a long term buy and hold investor and or have a sizable account balance.

Read Part I of this article here.

Matt Thalman Contributor - ETFs
Follow me on Twitter @mthalman5513

Disclosure: This contributor did not own shares of any asset mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from for their opinion.