Don't Sweat ETF Fees

Investors have been indoctrinated with the belief that mutual fund fees only rob them of performance and therefore should be avoided or minimized to the extent possible.

As far as mutual funds are concerned, that's probably true, since few active managers are able to consistently outperform their benchmarks anyway. But for ETFs it's different -- fees are largely irrelevant.

Now, before you stop reading, all else being equal, fees do matter. But rarely --if ever -- is all else equal. Fees for ETFs have been reduced to such an extent that a difference of a few basis points in costs between funds is likely to be overwhelmed by the difference in performance of the underlying investments.

That makes fees a secondary and far less important consideration.

For example, among several large-cap domestic-stock ETFs, the S&P 500 SPDR (SPY Quote), with an annual fee of 10 basis points, returned 15.8% in 2006, while the Dow Industrials Diamonds (DIA Quote), with an annual fee of 18 basis points, returned 18.9%.

The large-cap iShares Russell 1000 (IWB Quote), at 15 basis points, was up 15.4% last year, and the Nasdaq 100 Trust Shares (QQQQ Quote), at 20 basis points, gained only 7.1%.

Among all those large-cap domestic stock funds there is a spread of no more than 10 basis points in fees, yet a difference in performance of 11.8 percentage points.

And don't assume that the difference evens out in the long term: Over the past five years, the spread in cumulative performance is 23.4 percentage points.

It would be absurd to assume that over the next five years the cumulative performance of these funds will be within 0.5 percentage points of each other -- yet that is all the impact that the difference in fees between the most expensive fund and the least expensive fund will have.

You'd find similar divergence in returns if you examine small-cap ETFs, ETFs within a certain geographic category or even ETFs from the same fund company targeting growth stocks.

In fact, among the 74 iShares ETFs from Barclays Global Investors with at least five years of trading history, there is only minimal correlation between expense and performance. And for what it's worth, higher-fee funds had better total returns than lower-fee funds.

Further examination of the data reveals that the relative outperformance of international stock funds, which also tend to have higher fees, was the cause. Comparing fees and returns within each category reveals that the correlation between the two is statistically insignificant -- in other words, fees are largely irrelevant.