Zero-fee ETFs look free on the surface, but their revenue comes from overlooked mechanisms such as securities lending, bid-ask spreads, internal index construction, cash drag, and ecosystem cross-selling. Investors often miss the real costs behind “free” investing. This article explains how zero-fee ETFs actually generate money, the hidden risks, and what smart investors should evaluate before choosing these funds in 2025 and beyond.
Introduction: Zero-Fee ETFs Look Free — But Are They Really?
When zero-fee ETFs first launched, retail investors celebrated. Financial media praised them as the next revolution in passive investing. Advisors recommended them widely. And investors assumed they’d found the perfect investment vehicle: zero cost, zero friction, zero downside.
But Wall Street professionals asked a different question:
“If an ETF charges nothing, where does the money actually come from?”
Because no financial institution operates at a loss forever.
And as it turns out, zero-fee ETFs are not actually free. They generate revenue. Often a lot more than investors realize.
This article uncovers the hidden fees and structural trade-offs inside zero-fee ETFs — and reveals how they really make money behind the scenes.
Why Zero-Fee ETFs Became So Popular
The growth of zero-fee ETFs didn’t happen by accident. It was the climax of an intense pricing war between major ETF providers like:
- Vanguard
- BlackRock (iShares)
- Fidelity
- Schwab
Since 2008, the average ETF fee has dropped sharply. Morningstar reports that:
ETF fees fell from 0.40% to just 0.19% between 2008 and 2024.
Once fees approached zero, the giant firms figured out alternative revenue models.
That’s when “free” ETFs were born — not out of generosity, but strategy.
The Secret Behind Zero Fees: The Revenue Comes From Elsewhere
Zero-fee ETFs aren’t free. They simply don’t charge you in the way you expect.
Instead, they use several hidden or indirect revenue sources that most investors never look at.
Here’s what’s really happening.
1. Securities Lending: The #1 Revenue Engine Behind Zero-Fee ETFs
Most investors don’t realize that ETF providers loan out shares of the stocks or bonds inside the ETF — usually to:
- hedge funds
- short sellers
- high-frequency traders
Borrowers pay fees for those shares. These fees often exceed what the ETF would have collected in an expense ratio.
Why this matters:
- High-demand stocks generate huge lending fees
- The ETF provider keeps the majority of the income
- Investors rarely know how much lending is happening
Real-life example:
During the GameStop short squeeze, ETFs holding GME made enormous lending profits — far more than their annual management costs.
Zero-fee ETFs rely heavily on this revenue, sometimes lending out more aggressively than standard funds.
2. Bid-Ask Spread Costs: The Hidden Fee You Pay Every Time You Trade
Even if an ETF has 0% expense ratio, you still pay a trading cost called the bid-ask spread — the difference between the buy price and the sell price.
Zero-fee ETFs often have:
- Lower trading volume
- Wider spreads
- Less liquidity
This means:
You might save 0.03% annually but pay 0.12% per trade in spreads — a hidden cost bigger than the fee you avoided.
Spreads are not “fees,” but they act like fees and silently erode returns over time.
3. Proprietary Indexes: Zero-Fee ETFs Don’t Use S&P 500 or MSCI
Most investors assume a zero-fee ETF tracks a well-known index, but that’s not true.
To reduce expenses, issuers build their own indexes:
- Fidelity has Fidelity-created indexes
- Schwab has Schwab indexes
- Vanguard works closely with FTSE/CRSP but sometimes builds internal structures
Why this matters:
- No licensing fees → more profit
- Issuer has full control over the index
- Holdings may differ from the benchmark you expect
- Performance may diverge subtly
Investors might unknowingly own a portfolio that behaves differently from the S&P 500, Russell 1000, or Nasdaq.
4. Payment for Order Flow (Indirect Revenue)
Some brokerages route ETF trades to market makers in exchange for payment for order flow (PFOF).
ETF issuers indirectly benefit through:
- tighter trading relationships
- higher volumes
- more order flow
- greater ecosystem control
It’s not a cash transaction you see — but it is a revenue source within the ETF ecosystem.
5. Float Income: Interest Earned on Cash Held Inside the ETF
Zero-fee ETFs sometimes keep larger cash positions than traditional index funds.
This cash earns interest — often 4–5% in 2024–2025.
How float income works:
- Every ETF holds some cash for liquidity
- Zero-fee ETFs may hold slightly more
- Issuer keeps the interest
- Investors rarely notice
Cash drag may affect performance, but float income offsets the provider’s operating costs.
6. Cross-Selling Into Higher-Margin Products
Zero-fee ETFs act as loss leaders — a strategy used in retail:
Give away one product for free
→ to attract customers
→ who will later pay for premium services.
ETF issuers profit through:
- active funds
- retirement accounts
- managed portfolios
- advisory platforms
- margin lending
- options trading
- wealth management services
The ETF is free.
The ecosystem is not.
7. Scale Economics: Massive Firms Can Afford Zero-Fee ETFs
The ETF giants operate trillion-dollar businesses.
Serving millions of customers lowers overall cost per user.
Zero-fee ETFs help them:
- bring in new customers
- scale their infrastructure
- negotiate better spreads
- automate trading
- increase securities lending volume
The profit isn’t from the ETF — it’s from the empire.
Are Zero-Fee ETFs Riskier Than Traditional ETFs?
Not necessarily — but they are different and often misunderstood.
Potential risks include:
- opaque proprietary indexes
- increased securities lending
- tracking error
- wider bid-ask spreads
- lower liquidity
- subtle performance drift
- cash drag
- structural incentives to prioritize revenue
They’re not bad — but they are not identical to mainstream ETFs from VOO, SPY, or QQQ.
Real-Life Examples of Investors Surprised by Zero-Fee ETFs
Example #1: The Trader Who Paid More in Spreads Than Fees
A young investor buys a zero-fee ETF three times a week.
He saves $20 in management fees — but loses $80 to spreads.
Net negative.
Example #2: The Mismatched Index
An investor thinks he’s buying an S&P 500 clone.
Later he learns the zero-fee ETF uses a proprietary index with different sector weights.
Performance diverges.
Example #3: Securities Lending Surprise
A zero-fee ETF holding small-cap stocks earns massive lending revenue — but the borrowing pressure causes temporary tracking error.
These small surprises become big lessons.
What Americans Are Searching About Zero-Fee ETFs in 2025
- “Are zero-fee ETFs really free?”
- “How do zero-fee ETFs make money?”
- “Are zero-fee ETFs a scam?”
- “What are the risks of zero-fee ETFs?”
- “Do zero-fee ETFs track worse than S&P 500?”
- “Why would a company give away an ETF?”
- “Is securities lending safe?”
- “Should I replace VOO with a zero-fee ETF?”
- “Do zero-fee ETFs underperform?”
- “Are proprietary indexes risky?”
This article addresses all of them directly.
How Investors Can Protect Themselves From Hidden Costs
✔ Understand spreads — the real silent cost
If spreads are wide, the ETF isn’t truly free.
✔ Check index methodology
Proprietary indexes may behave unexpectedly.
✔ Look at tracking error
Zero-fee ETFs sometimes trail their benchmarks.
✔ Analyze the fund’s securities-lending policy
Who keeps the revenue — the fund or the issuer?
✔ Avoid thinly traded zero-fee ETFs
More trading = more spread friction.
✔ Compare with well-known ETFs like VOO, SPY, SCHB
Sometimes 0.03% annual fees are worth it.
✔ Consider long-term portfolio impact
What matters is total return — not headline fees.
✔ Review annual reports for revenue sources
Most people never do — but should.
✔ Look at AUM
Small zero-fee ETFs may have unstable liquidity.
✔ Balance “free” and “proven”
Mixing zero-fee ETFs with traditional funds provides stability.
Top 10 Frequently Asked Questions (FAQ)
1. Are zero-fee ETFs really free?
The expense ratio is free, but you pay through spreads, tracking differences, and hidden revenue channels.
2. How do zero-fee ETFs make money?
Mostly through securities lending, spreads, cash drag, and ecosystem cross-selling.
3. Are they safe to invest in?
Yes, structurally — but they may behave differently from well-known ETFs.
4. Is securities lending dangerous?
Not usually, but it adds a small counterparty risk.
5. Do zero-fee ETFs underperform?
Sometimes — especially if spreads or tracking error are high.
6. Why do companies offer free ETFs?
To attract customers to their ecosystem and profit elsewhere.
7. Should I replace VOO or SPY with a zero-fee ETF?
Not always. Liquidity, index quality, and tracking often matter more than a 0.03% fee.
8. Do proprietary indexes change performance?
Yes — weights and holdings may differ.
9. Do spreads hurt long-term investors?
Less so — but frequent traders feel the pain most.
10. How can I tell if a zero-fee ETF is right for me?
Evaluate liquidity, index transparency, spread cost, and long-term performance expectations.
Conclusion: Zero-Fee ETFs Are Innovative — But Not Truly “Free”
Zero-fee ETFs are one of the most important innovations in modern indexing.
They lower costs, expand access, and give investors more choices than ever.
But they also come with:
- hidden trading costs
- complex index structures
- securities-lending incentives
- indirect revenue channels
- subtle performance nuances
This doesn’t make them bad — it makes them misunderstood.
Smart investors look beyond the “0.00%” marketing and evaluate total cost, transparency, and long-term reliability.
In investing, free is never truly free — and the most expensive mistake is assuming it is.
