Zero-fee funds aren't a 'free lunch' — here's what to watch out for when you invest

"The hope with these firms is that you build a portfolio using the free funds" and pay for others.


The idea of investing in an ETF or mutual fund with no expense ratio brings two maxims of the investing world into direct conflict. On one hand, investors are told to keep costs as low as possible. After all, what you pay for your investments is just about the only thing about them that you can control. And research has shown time and time again that low expenses are the number one predictor of investment success over time.

One the other hand, read just about any investing or finance book and you're likely to stumble across some variation of the popular adage "there's no such thing as a free lunch." If Wall Street is telling you as an individual investor that something is free, chances are you're paying for it in some other, not-insignificant way.

So when Invesco debuted two new fee-free ETFs last week, it shouldn't have come as a shock that there's a catch: Invesco is only waiving the expense ratio for the first six months, at which point the expense ratio jumps to 0.19%.

Even if there's an unexpected trade-off when it comes to these and other "free" funds, that doesn't mean you shouldn't invest. Read on to find out why.

Free ETFs are designed to get you in the door

There are a handful of funds out there that will never charge you a penny in expenses. Fidelity became the first investment firm to offer such funds starting in 2018, rolling out four index mutual funds that track the total stock market, large U.S. stocks, small- and midsize company stocks, and international stocks, respectively.

The company's move was akin to the banks giving out free toasters. Because only Fidelity clients could invest in the funds, the hope was that they could get you through the door with the shiny free thing in order to sell you more expensive services down the line.

Other firms have followed a similar model. The BNY Mellon US Large Cap Core Equity ETF, for instance, tracks an index of large-company U.S. stocks and charges nothing in expenses. "BNY Mellon is the company that owns Pershing, which is a network for financial advisors," says Todd Rosenbluth, head of ETF and mutual fund research at CFRA. "This fund serves as an added benefit that those advisors can offer to their end customers."

The same calculus is likely at play at SoFi, Rosenbluth says, a late entrant into the investing game that's currently waiving expenses on two ETFs. "The hope with these firms is that you build a portfolio using the free funds and then keep using the other ones within the family," he says. "SoFi has a brokerage platform, and they're trying to be a strong alternative to Fidelity or Schwab or Robinhood."

Investigate what you're buying with 'free' funds

Invesco's new ETFs differ from the other free offerings on the market because they each track a much narrower swath of the market, with one fund tracking biotechnology stocks and the other following a semiconductor index. In each case, the funds will track a preexisting index, such as the Nasdaq Biotechnology Index. This makes tracking past performance easy, notes Rosenbluth.

"Up until next week, iShares Nasdaq Biotechnology ETF will have tracked that same index," he says. "Until that ETF switches to another index, you can see exactly how this portfolio performed."  

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If you're interested in either of those sectors, the Invesco ones are worth looking into, at least in the short term, says Rosenbluth. "You'll just have to remember to review your investment at the six-month mark," he says. And even if, like that free AppleTV trial, you forget to cancel, the 0.19% expense bump is reasonable, he notes. "That's not zero, but it's relatively cheap."

The other free funds on the market tend to track a facsimile of a major index without exactly replicating it. That's because fund firms must pay licensing fees to index providers in order to create funds that track a particular benchmark. To save on costs, fund providers set up their own proprietary indexes that the free funds follow. That can mean a slight divergence in performance. The Fidelity ZERO Large Cap Index fund, which tracks a proprietary version of the S&P 500, for instance, has returned 12.34% year to date, compared with a 13.70% return for the Vanguard S&P 500 ETF, which charges 0.03% to investors to track the real thing.

The fund you're looking at may not track the index you're expecting at all. Despite its name, the SoFi Select 500 ETF doesn't track the 500 largest U.S. stocks, but a portfolio that tilts toward faster-growing names.

Nevertheless, if you know what you're signing up for, it's never a bad idea to get broad market exposure for free, says Rosenbluth. "These products have been around for a little while. Look at the difference and decide if it matters to you or not," he says. "If you look at the portfolio, these funds will hold all of the stocks you expect. If you want large-cap exposure and don't want to pay anything for it, it's probably worth it."

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