Portfolios With the Lowest-Cost Mutual Funds and ETFs

Earlier this week, Christine Benz—Morningstar’s director of personal finance and retirement planning—started a discussion on Twitter about why bond mutual funds charge lower expense ratios than stock mutual funds. If the topic surprises you, look at the category averages in our mutual fund guide. Except for high yield, every bond category has a lower average expense ratio than the cheapest stock category: large-cap stocks.

There isn’t an evidence-based answer I can give you as to why this is the case. Research, analysis and trading costs are incurred by both stock and bond funds. My assumption is that there is less leeway to charge higher fees on bond funds. Bonds have lower long-term returns than stocks, so expense ratios have a more noticeable impact on bond fund net returns.

Benz’s tweet sparked a different idea: What would diversified portfolios comprising the cheapest mutual funds and exchange-traded funds (ETFs) look like? Cheapest in this case is defined as having the lowest expense ratio. Bogleheads (adherents of the late John Bogle) might be surprised by the answer, because Vanguard funds only have a small presence in the portfolios shown below.

Before we take a look at those cheap diversified portfolios, I’ll explain how I created them. (Feel free to scroll down if you just want to see what made the cut.) I used the same criteria we used for creating our mutual fund and ETF guides. Those rules included minimum asset sizes, no loads and no institutional or special share classes for mutual funds, minimum trading volume for ETFs and no leveraged or inverse funds. I excluded asset allocation funds since many are funds of funds and their underlying holdings incur expenses of their own.

Let’s start with the cheapest mutual funds (expense ratios are on the right):

• Large Blend: Fidelity Total Market Index fund (FSKAX), 0.01%
• Mid-Cap Blend: Fidelity Mid Cap Index fund (FSMDX), 0.03%
• Small Blend: Fidelity Small Cap Index fund (FSSNX), 0.03%
• Foreign Large Blend: Fidelity International Index fund (FSPSX), 0.04%
• Diversified Emerging Markets: Fidelity Emerging Markets Index fund (FPADX), 0.07%
• Intermediate Core Bond: Fidelity U.S. Bond Index fund (FXNAX), 0.03%
• Short-Term Bond: Vanguard Short-Term Bond Index Admiral fund (VBIRX), 0.07%

The simple average of these funds’ expense ratios is 0.04%. This equates to a cost of $0.40 per year for every $1,000 invested. In comparison, a portfolio of funds with average expense ratios of 1% would cost you $10 per year for every $1,000 invested. Clearly, paying $0.40 is a lot better than paying $10. Your portfolio’s actual expense ratio will depend on the funds used and how they are weighted.

Now let’s look at ETFs. Again, the expense ratios are to the right of the ETF’s name.

• Large Blend: JPMorgan BetaBuilders U.S. Equity ETF (BBUS), 0.02%
• Mid-Cap Blend: Schwab U.S. Mid-Cap ETF (SCHM), 0.04%
• Small Blend: Schwab U.S. Small-Cap ETF (SCHA), 0.04%
• Foreign Large Blend: iShares Core MSCI International Developed Markets ETF (IDEV), 0.04%
• Diversified Emerging Markets: Vanguard FTSE Emerging Markets ETF (VWO), 0.08%
• Intermediate Core Bond: iShares Core U.S. Aggregate Bond ETF (AGG), 0.03%
• Short-Term Bond: Vanguard Short-Term Bond ETF (BSV), 0.04%

The simple average is again just 0.04%. The average expense ratio increases due to the inclusion of the emerging markets ETF, but the difference is minimal. The average expense ratio is 0.041% with the Vanguard FTSE Emerging Markets ETF included and 0.035% without it. Again, how you allocate will impact the cost of the portfolio.

There are 86 no-load mutual funds and 164 ETFs with expense ratios of 0.10% or lower meeting the basic criteria we used. While cost matters, other factors gain importance when you get to such low expense ratios.

Take performance, for instance. While having to realize a half or full percentage point of return each year just to match the net return of a low-cost fund is a big hurdle for a fund, outperforming by a small number of basis points (bps) each year is not. (A single basis point equals 1/100 of a percentage point, or 0.01%. The difference between a fund with a 0.10% expense ratio and a 0.04% expense ratio—six bps—is $0.60 for every $1,000 invested.) In such instances, it makes sense to pay a tad bit extra on the expense ratio for the fund with the better historical record.

Some of the mutual funds and ETFs have A+ Investor Grades of D or F for their return over certain time periods. These grades indicate that the funds’ performance ranked in the second-lowest or lowest quintile of performance for the period measured.

For a difference of just a few basis points in expense ratio, it is possible to find alternatives with better return track records. The Fidelity Small Cap Index fund could be substituted with the Vanguard Small-Cap Index Admiral fund (VSMAX). The difference in cost is just two bps: 0.03% versus 0.05%. The Vanguard Small-Cap Index fund has delivered higher returns over the past one-, three-, five- and 10-year periods.

Other considerations include—but are not limited to—the fund’s strategy or index followed, transaction cost considerations, tax efficiency, yield, etc. There is also your time and effort.