Can you keep a secret? Affluent investors are becoming big fans of Exchange Traded Funds (ETF). While Wall Street may want to continue to pick your pocket through higher-cost mutual funds, you can lower your costs and need to get to know about ETFs.
Wall Street doesn’t want you to know that you may not be getting the best deal when it comes to your investments. Most people invest through mutual funds but there is a better and less expensive way to invest. Exchange Traded Funds (ETFs) are winning the hearts, minds and wallet share of affluent investors. And you should consider them for yourself, too.
In much the same way that index funds have attracted billions from investors because they offer a different and lower cost approach to investing compared to actively-managed mutual funds, ETFs continue to attract dollars because of their unique structure and blend of benefits at an even lower cost.
Mutual Funds: Active versus Passive
Most investors are familiar with mutual funds which offer access to professional management for a relatively low investment minimum. These funds allow investors to pool their money with a money manager who then invests in stocks, bonds or other investments. You can choose an “active” approach where the money manager’s team actively screens and picks investments and may actively buy and sell the underlying investments based on their own investing method. Or you can choose a “passive” approach where the money manager is paid to build a portfolio that mimics a particular benchmark for bonds or stocks.
Neither approach is right or wrong and there are times when one investment style or another (value versus growth or active versus passive) will win out. There continues to be a long-running debate over the merits of each approach. Research shows that while some actively-managed funds do better than their portfolio benchmark most (some reports say over 85%) tend to under-perform over time.
Why I Heart ETFs
When it comes to investing, you may be personally very involved or very laid back. Regardless of which kind of investor type you are, you really need to get to know ETFs and how they can help you with your investment returns and lower your expenses. I’ve posted on this in greater detail here.
For a host of reasons I’ve long-since adopted ETFs to build out core portfolio positions in our MarketFlex Portfolios. ETFs offer access to hard-to-reach investment areas in Emerging Markets and certain industries or investments like Master Limited Partnerships (MLPs). I can use ETFs like a mason uses bricks. Since each one may represent a different industry, broad sector or geographic region, I can design a customized portfolio or model for a client and know exactly what’s “under the hood” of each investment instead of guessing if a mutual fund manager actually invests in what he says he will. Because they are structured from a basket of securities, they offer instant diversification like a mutual fund but with the added benefit of real-time pricing and trading throughout the business day.
And if you believe, as I do, that it’s hard to find a new way to score an advantage over someone else on Wall Street (a form of the Efficient Market Hypothesis used in finance), then it makes sense to gain exposure to these broad market areas for the lowest possible price.
Costs Matter – Understanding Your Expense Ratio
Compared to an actively managed mutual fund, ETFs are downright cheap. Morningstar reports that the active mutual fund has an expense ratio cost that ranges from 0.80% to 1.50% per year and the Financial Analysts Journal reports an average around 1.44%. I think it’s more … way more.
This expense ratio covers the costs reported for owning a particular fund but not everything.
It consists of three main components:
- Investment Management: All those portfolio managers, staff and researchers have to be paid somehow. This is the bulk of the fee and can range from 0.5% to 1%.
- Administrative Costs: Let’s face it. It costs something to have offices in shiny tall buildings with granite or wood panels. And there’s all the stuff that goes with that office: phones, lights, single-shot coffee K-cups. Let’s not forget about the very highly-illustrated graphics and printed materials. This portion can range from 0.20% to 0.40% per year.
- Marketing, Advertising and Distribution Costs (12b-1 Fees): This is how the mutual fund pays for all those magazine ads and creative commercials and compensates a registered securities salesperson who introduced you to the fund. For the privilege of seeing those commercials and sundry services, you’ll pay anywhere from 0.25% to 1.00% more per year.
Invisible Costs Drag Down Performance
I tend to think that number is actually higher because that number from Morningstar doesn’t include the underlying costs for the portfolio management team to trade (buy and sell) their positions. These portfolio trading, commission and price spread costs are mostly invisible and not part of the published expense ratio.
We in the trade can infer them from the “portfolio turnover” rate reported by the mutual fund but other research reported in the February issue of the Financial Analysts Journal indicates that trading costs are almost as high as reported expenses. So you may need to actually add another 1% to the cost of owning that mutual fund that “leaks” away silently just because you are invested with a particular money manager.
This research “did find a strong negative relation between aggregate trading costs and fund return performance.” Well, ya think?!? Mutual fund costs are a drag – like a sea anchor – on your investment performance making it that much more difficult to get over the hurdle into positive return territory.
The Rich Know the Secret – And Now You Know, Too
So, it’s no wonder that the very wealthy are attracted to ETFs and using them more. The rich didn’t get that way by paying for fees needlessly. According to a Spectrem Group survey reported in ETF Trends (www.etftrends.com), more than 47% of wealthy investors (those with more than $5 million to invest) use ETFs compared to just 28% of all investors.
You don’t have to be a multi-millionaire to invest in ETFs. And you don’t need to be rich to save money. Now that you know more about what you’re paying, what will you do about it?
