5 Things To Consider Before Buying This Popular Investment, According to Fidelity

Low-cost index funds have been one of the most recommended investing methods for the past 30 years. These funds track the market or groups of companies, which lowers risk.

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However, because these exchange-traded funds (ETFs) are everywhere, it makes it harder to choose one that will work best for you. Fidelity, one of the main providers of ETFs, recently released a blog post, “How to shop smart for ETFs.” Here’s what Fidelity had to say and how anyone can apply it to their investment strategy.

The expense ratio is the annual fee a fund takes from its assets to pay for running the fund. Think of it as the “subscription fee” that is quietly deducted each year. Fidelity stresses comparing funds that track the same index because their before-fee performance should be nearly identical.

Small percentages compound. A 0.20% fee instead of 0.03% on $25,000 is $42.50 more in year one. Over many years, the gap will grow through compound interest. FINRA, a regulatory organization, provides a Fund Analyzer tool that you can use to compare funds.

Beginner tips:

• Check if today’s low fee relies on a temporary “fee waiver.” If so, plan for the higher number that kicks in after the waiver ends.

• If two funds track different indexes (say S&P 500 vs. total market), pick the benchmark you want first. Then compare fees only among funds that track that same benchmark.

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Transaction costs are the one-time charges to buy or sell. Many brokers now offer $0 online commissions for ETFs, including Fidelity.

If you invest monthly, a $50 or $75 ticket each time would overwhelm any small fee edge on the expense ratio.

Beginner tip:

ETFs trade like stocks, so two prices are always displayed on screen: the bid (the price at which buyers are willing to buy) and the ask (the price at which sellers are willing to sell). The spread is the difference and is a real cost that should be factored in.

Big, broad stock ETFs tend to have smaller spreads. Niche funds can be wider.

You can use a limit order to set the most you’re willing to pay. This protects you from a sudden price swing. Fidelity notes that you can use the same order types with ETFs that you use with stocks.

Beginner tip:

ETFs work by tracking an index — a rule-based list that represents a slice of the market, such as the S&P 500 for large U.S. stocks. However, you can’t buy the index itself; it’s just a measuring tool. Instead, you can buy an ETF that tries to match that index as closely as possible.

Tracking difference measures how well the ETF tracks the index it’s based on, comparing the fund’s return to what the index’s return would have been over a period. If the index earns 8.0% and the fund earns 7.7%, the tracking difference is -0.3 percentage points.

Tracking error describes how much the shortfall wiggles from period to period. Is it steady or does it keep changing? A small, steady gap means low tracking error, while a gap that jumps around means higher tracking error.

Why do gaps happen? Some funds own every security in the index, while others sample to keep costs down, which can increase drift. Dividends arrive in cash and may not be reinvested immediately. International funds can lose a slice to foreign dividend withholding taxes. Fidelity recommends comparing results over several years against the stated index and versus a close peer — especially with bond and international ETFs, where perfect replication is harder.

What you keep after taxes is what grows your account. In a taxable account, you owe tax each year on income the fund pays out and on any capital gains the fund distributes when it sells holdings at a profit. ETFs often reduce those capital-gains payouts by using in-kind swaps with big trading partners, which lets the fund hand off appreciated shares instead of selling them. That usually means fewer surprise tax bills than a traditional mutual fund, but not always.

What to do:

• If you’re investing in a 401(k) or IRA: Taxes are deferred or not due. Focus on the basics here — fees, tracking and liquidity. Tax differences among similar ETFs matter much less.
  

• If you’re investing in a taxable account: Treat taxes as a cost you can manage.

  1. Open the fund’s page on the issuer site and review its capital gains distribution history and turnover. Prefer the fund with a cleaner distribution record.

  2. For core holdings, favor broad, low-turnover index ETFs. Save high-turnover or income-heavy funds for tax-advantaged accounts.

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This article originally appeared on GOBankingRates.com: 5 Things To Consider Before Buying This Popular Investment, as reported by Fidelity