Fidelity Offering Free iShares ETF Trading

In early February, Fidelity announced, via a press release, that they would begin offering investors commission-free trades in 25 iShares exchange-traded funds (ETFs). In the days since, I have been struck by the fact that the financial news media lapped up the press release and largely regurgitated and lauded it without asking some relevant questions and doing some basic analysis.

I wondered, as I always do when I hear about something supposedly being offered for free, "What's the catch?" I also wondered how these commission-free ETFs stacked up against the best competitors.

What's the Catch?

Of course there's a catch - there's always a catch when you're offered something for free, especially from a public company that has to report profits to shareholders every three months! (iShares is owned by Blackrock, a public company).

Many discount brokers, for example, offer you the ability to buy and sell shares of mutual funds outside their own family/parent company without paying a transaction fee. How can discount brokers offer commission free trades when they are directing the money to an outside management company? Such no transaction fee (NTF) funds are paying a portion of their management fee to the discount broker on an ongoing basis. I have written extensively about this over the years and highlighted when it makes sense to use discount brokers to centralize mutual fund holdings and pay transaction fees and which NTF funds are worth using. The vast majority of NTF funds are not among the best available funds because they have higher management fees or worse management/performance or both.

Now, back to iShares big splash announcement with Fidelity. iShares denies that they are paying Fidelity a portion of their ETF management fees. It appears that iShares and Fidelity are doing promotion for one another - an "I scratch your back if you scratch my back" type agreement. Fidelity gets to promote that their customers can trade 25 iShares ETFs for free and iShares gets their ETF program promoted by mutual fund behemoth Fidelity.

Comparing iShares to the Rest

Whenever I analyze any investment such as a mutual fund or ETF, I examine many factors including how it stacks up to the competition. While iShares has the largest market share among ETF providers, it offers few ETFs that I would recommend. In my roundup of the best index and ETF funds, I did recommend the iShares Russell 2000 Value Index ETF (IWN). As you can see in that same article, the No Load Fund Analyst newsletter highlighted a few of their other ETFs.

Let's examine how the iShares ETFs stack up when you can trade for free versus the competition. As a first test, I was curious how the iShares MSCI Emerging Markets Index ETF compared with Vanguard's Emerging Markets ETF. Both ETFs are designed to track the same index which I'll come back to in a moment. As for expenses, the iShares ETF has an annual expense ratio of 0.72 percent, which is nearly triple that of Vanguard's ETF at 0.27 percent. So, if you invested $5,000 in each of these ETFs, you would pay $36.00 in operating expenses annually for iShares and just $13.50 for Vanguard. And, remember, you pay operating expenses every year so being able to trade the iShares ETF for free is hardly worthwhile.

The higher operating expenses of the iShares ETFs are a significant drawback but there are others. Vanguard's ETFs have done a much better job tracking their respective indexes and therefore have posted better performance numbers. Vanguard has far more expertise with designing and managing index products because they've been at it for decades. With the emerging market ETF, for example, Vanguard's holds 810 stocks whereas iShares tries to cut corners and match the index by sampling fewer stocks - it holds just 425 stocks. As a result, it has strayed from its index far more. For example, in 2009, the index posted a 78.51 percent return whereas the iShares ETF produced a 71.78 percent return, thus underperforming the index it's supposed to track by 6.72 percent.

So, all in all, investing in iShares ETFs through Fidelity for their free trading offer isn't worth pursuing. And, remember that you should always compare ETFs to index funds when deciding which may be best for your situation. See my article, "Are Exchange-Traded Funds Superior to Mutual Funds?"