All you hear about exchange-traded funds these days is how they're getting cheaper and cheaper—which is true. Since 2010, ETF expense ratios have fallen by a quarter, to 0.24% on average. In fact, some ETFs give you broad stock market exposure for as little as 0.03% a year.
But the management fees that fund companies charge aren't the only costs you must watch. There's also the price that your ETFs pay for the stocks they must hold. And thanks to a long bull market that recently celebrated its eighth birthday, those prices are rising to historic levels. "ETFs and index funds are cheap, and cheap is good," says Ben Inker, head of asset allocation for the money manager GMO. "But the market ain't cheap."
The price/earnings ratio for the S&P 500, based on 10 years of averaged profits, has climbed above 29 for the first time since the tech bubble (17 is the historical average). The only other time the market was this frothy was in the months leading up to the Great Depression.
Why Does This Matter?
Your expected returns, alas, are tied to how frothy an investment is. An AQR Capital study found that from 1926 to 2012, equities gained less than 1% a year, after inflation, in the decade after 10-year average P/Es rose above 25. But when that ratio dropped below 12, real annual gains jumped to more than 10%.
Valuations matter just like fees do. Morningstar looked at the performance of funds based on expense ratios and found that portfolios charging less than 0.5% gained 7.2% annually over the past decade. By comparison, funds charging 1% to 1.5% returned 6.6%, and those charging 1.5% or more returned just 5.7% a year.
"What is certain is every dollar you don't pay for management or administrative fees is a dollar you get to keep," says Joel Dickson, Vanguard's head of investment research and development.
So Where Can You Find Low Fees and Good Value?
• Foreign equity ETFs
While the U.S. looks expensive, foreign stocks are a different story. "Even if a U.S. ETF is charging just 0.05% and an international ETF is charging 0.20%, the fact that international stocks are a lot cheaper than U.S. equities means there's a good chance you'll still do better paying the higher fees for the international stock ETF," says GMO's Inker.
Among the cheapest all-around funds is Schwab Fundamental Emerging Markets Large Company ETF (FNDE), which charges just 0.4% in fees and sports an average P/E of just 9.4.
• Deep-value funds
In the U.S., the cheapest ETFs focus on the most beaten-down shares, like PowerShares S&P 500 Value (SPVU). This ETF tracks an index of the 100 cheapest S&P 500 stocks based on several valuation gauges, including P/E ratios. The fund, which charges only 0.25%, has an average P/E of just 13.