The index fund fee wars continue… You may or may not know that Blackrock’s iShares is the largest ETF provider in the world, with over 250 US-listed ETFs and the largest asset base by a good margin. iShares ETFs tend to have big volume and are the favorites of Wall Street traders and also large money managers. But Vanguard is catching up, and iShares responded by making a move in October 2012 to appeal to long-term, buy-and-hold investors who want low-cost, broad, index ETFs. (I’m sure they also saw how people who wanted Emerging Markets exposure quickly switched from EEM to VWO due to the big fee difference.) See the official iShares press release for more details.

Below are the 10 ETFs that comprise the new iShares Core Series ETFs (4 new, 6 modified existing), along with their expense ratio, ticker symbol, and benchmark index. They are broken down into 4 US equity ETFs, 3 International equity ETFs, and 3 US bond ETFs.

The new expense ratios are very competitive with the corresponding Vanguard ETFs, usually within a few basis points. It would have been nice if they just lowered the fees on EEM instead of starting a whole new ETF IEMG, but remember that profit motive. The ETFs are gaining reasonable assets, so it appears to be a successful move so far.

For the individual investor, it will be interesting if iShares strikes a deal with a major brokerage firm to offer commission-free trades on these ETFs. Update: These Core ETFs are now part of Fidelity’s commission-free iShares ETF list .

Fidelity Investments made some cost-cutting moves recently to try and keep their index fund products competitive (full press release). This comes at the same time that their actively-managed equity funds are seeing large amount of withdrawals, per WSJ:

Investors pulled a net $35.3 billion from equity funds at the country’s second-largest mutual-fund company in 2012, according to Fidelity’s annual report released Friday. Of that total, the Boston-based company’s actively-managed stock funds – an essential component of its business – saw outflows of $24.4 billion during the year. That’s despite the strong performance of the funds, which collectively beat 74% of their peers last year, compared with 53% in 2011, according to Fidelity.

(Also noteworthy: Fidelity filed with the SEC in December 2011 to roll out their own line-up of index-tracking stock and bond ETFs, although I haven’t heard much since. In December 2012, Fidelity filed to start actively-managed ETFs as well.)

Reduced investment minimums. As of December 2012, Fidelity reduced the investment minimums on 22 equity and bond funds, including the 14 Spartan index funds listed below. The Investor Class investment minimum was lowered from $10,000 to $2,500, while the Fidelity Advantage® Class was lowered from $100,000 to $10,000.

Spartan 500 Index Fund
Spartan Extended Market Index Fund
Spartan International Index Fund
Spartan Total Market Index Fund
Spartan Emerging Markets Index Fund
Spartan Global ex U.S. Index Fund
Spartan Mid Cap Index Fund
Spartan Real Estate Index Fund
Spartan Small Cap Index Fund
Spartan Inflation Protected Index Fund
Spartan Intermediate Treasury Index Fund
Spartan Long-Term Treasury Index Fund
Spartan Short-Term Treasury Index Fund
Spartan U.S. Bond Index Fund

This is a pretty big move to bring in more retail investors, becoming more in line with Vanguard’s Investor and Admiral Class shares. As with Vanguard, share class conversions should occur automatically based on your investment amount, and the conversion is a tax-free event.

Lower expense ratios. As of January 2013, Fidelity also cut the overall expense ratios for certain share classes of 8 Spartan index funds. Below is a list of the affected funds and their new expense ratios for Investor/Advantage classes as of 1/1/13.

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Recently, Vanguard has made some big moves in the index fund space. Well, they were big for people in the business, but for individual investors it basically boiled down to some simple good news: even lower costs, which happily means larger numbers on my monthly statements.

In October 2012, Vanguard announced that they would be changing the benchmarks on 22 of their index funds from MSCI indices to either FTSE (international) or CRSP (domestic) indices. Essentially, companies like S&P (S&P 500) and MSCI are the “brand names” of the indexing world. However, creating an investable market-cap weighted index has basically become a commodity, so why not go “generic” where available? FTSE is part of a publicly traded company, but CRSP is short for University of Chicago’s Center for Research in Security Prices which is run as a non-profit.

Basically, MSCI wanted too much in licensing fees, so Vanguard dropped them. Remember that with Vanguard’s client-owned structure, the savings goes to the investor and not to shareholders or private owners. This move should result in lower expense ratios in the affected funds as well as the popular Target Retirement 20XX and LifeStrategy funds. Vanguard is taking the transition slowly over several months in order to minimize any capital gains, front-running, or market impact costs. Here is a list of all the affected funds and the new benchmarks. Notable changes include:

• Vanguard Total Stock Market Index Fund (VTSMX, VTSAX, VTI) will now track the CRSP US Total Market Index. It shouldn’t change significantly, but the new CRSP index does include more micro-cap stock exposure.
• Vanguard Total International Stock Index (VGTSX, VTIAX, VXUS) will now track the FTSE Global All Cap ex US Index. Here is another nice overview on the Rick Ferri Forbes blog, but basically there will only be slight changes.
• Emerging Markets Stock Index Fund (VEIEX, VEMAX, VWO) will now track the FTSE Emerging Index. The big change here is that FTSE has South Korea as a Developed market, whereas MSCI still has South Korea as a Emerging market. South Korean stocks were 15% of the MSCI-based ETF, so the new ETF should look a little different. This was going to happen sooner or later, anyway.

Bottom line: Vanguard disrupted the industry again, and others may have to follow eventually. Vanguard already has the asset size and client-owned structure that gives them the ability to maintain the lowest costs in the industry. Other providers may match or even beat their expense ratios, but they are doing it as a loss-leader and hoping to make it up elsewhere. Like milk or orange juice at the grocery store, this means whatever is on sale today may go up in price next week (or year, or decade). The difference is that when it comes to long-term investing, over time you will (hopefully) accumulate significant capital gains and selling them prematurely will results in a tax hit. I don’t want to have to switch investments later on in the game.

When you look up the historical performance of mutual funds, you are typically getting what is called a time-weighted return. For example, the 5-year return is what you would have gotten if you bought the fund five years ago and held it continuously until today, all the while reinvesting dividends, with no additional purchases or withdrawals.

But real life is different. People add money in, people take money out. Morningstar calculates an additional metric called Investor Return [pdf], also known as a dollar-weighted return. This measures the returns that investors actually achieved in that fund, based on dollar inflows and outflows. This means that if investors as a whole timed their purchases correctly and bought more shares when the fund was low, then their returns would actually be higher than the time-weighted returns. If instead, investors waited until the fund performed well before buying in, and/or sold their shares only after the price was temporarily lagging, then their dollar-weighted returns would be lower than the time-weighted return.

Russell Kinnell of Morningstar has a revealing article and chart comparing the performance of the average fund with the average investor, broken down by category like US stocks or municipal bonds. This higher-level view is useful because it takes out any noise you might get from just looking at a specific mutual fund. Did the average investor’s market timing efforts pay off? Here are the results, broken down into the past 3, 5, and 10-year periods.

Source: Morningstar

We see that across almost every category and every timeframe, the investor return lags the fund return. That gap also tends to grow over time, with an average underperformance of nearly 1% a year over the last 10 years. That’s a lot of money. The S&P 500 is basically back to it’s all-time high back in 2007, even though it was a crazy roller coaster in between, and it seems most people didn’t time it correctly. It would be wise to remember this consistent underperformance this the next time you think about market timing, or buying something simply because it did well in the recent past.

Halfway Update – 5 Years Later! Carol Loomis has posted the 5-year update in Fortune of the $1,000,000 index fund vs. hedge fund bet. Halfway through the 10-year bet (1/1/08 to 12/31/17), the Vanguard S&P 500 index fund backed by Buffett is up by 8.69%. The group of hedge funds hand-picked by Protégé Partners are up by 0.13%. Note that the index fund had been lagging just about ever year since this one, but that’s why we are looking at a longer period. Consider this halftime. 🙂

It will be very interesting to see how this turns out. Hedge funds charge fees of roughly 2% of assets annually + 20% of any gains. You may notice that five years of 2% fees would be 10% (ignoring the compounding effect for simplicity), and the hedge funds are lagging by about 9%. Costs matter!

You can read the terms of the bet and each side’s arguments at LongBets.org (also see original Fortune article below for backstory). This carefully-tracked bet was part of the inspiration for my transparent Beat the Market experiment. Too often, people are not honestly and accurately tracking the total performance of their portfolios. These ongoing updates help illustrate how hard it is to consistently beat a low-cost, diversified portfolio over the long run, and how it’s incorrect to declare yourself a winner even after several good years. Who knows, the hedge funds may still win.

Original blog post from 2008:
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