ETFs are something like a hybrid between a mutual fund and traditional equity shares. ETFs hold assets such as stocks, commodities or bonds, and are designed to trade close to its net asset value (NAV) over the course of the trading day, much like common equity would.
Conversely, a traditional open-end mutual fund does not trade throughout the day, but instead adjusts its price after the markets close to reflect the NAV change that occurred that day. Other differences exist between most ETFs and mutual funds, including that several ETFs have considerably lower fees.
Low fees can make a huge difference over time. A $10,000 investment in a product with a 1% management fee will be charged $100. This fee may be static in percentage, but would actually go up if your investment appreciates. For example, if that investment appreciated to $15,000 after five years, then the annual management fee would also grow to $150. Even if the investment went nowhere for 10 years, the difference between a 1% and 0.5% fee would be about 5%, and for a 0.1% fee would be about 9%.
In fact, an investor whose fund went nowhere over the last decade likely saw fees go up when the market was higher in 2004 through 2007, and that a 1% annual fee actually ate over 10% of potential gains. These calculations get even more complicated and often more vile if reinvestment and compound growth are factored. Reducing fees is one sensible way to improve the performance of a portfolio, especially where those higher fee funds are not offering a compelling alternative to the static index-type portfolios that low-fee ETFs generally offer, and it turns out that most do not.
This is a comparison of several low fee large-cap ETFs. Each of these ETFs has an expense ratio of below 0.5% and an average trading volume above 200,000 shares. I have included expenses and current dividend yields, as well as their 2011-to-date performance:
iShares S&P 100 (NYSEARCA:OEF)
- Yield: 2.07%
- Fees: 0.2%
- 2011-to-date: -6.54%
iShares S&P 500 (NYSEARCA:IVV)
- Yield: 1.99%
- Fees: 0.09%
- 2011-to-date: -6.46%
Rydex S&P 500 Equal Weight (NYSEARCA:RSP)
- Yield: 1.52%
- Fees: 0.4%
- 2011-to-date: -7.33%
Schwab U.S. Large-Cap ETF (NYSEARCA:SCHX)
- Yield: 1.84%
- Fees: 0.08%
- 2011-to-date: -6.2%
SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA)
- Yield: 2.67%
- Fees: 0.18%
- 2011-to-date: -4.12%
SPDR S&P 500 ETF (NYSEARCA:SPY)
- Yield: 1.98%
- Fees: 0.1%
- 2011-to-date: -6.37%
Vanguard S&P 500 (NYSEARCA:VOO)
- Yield: 1.98%
- Fees: 0.06%
- 2011-to-date: -6.54%
Vanguard Large Cap ETF (NYSEARCA:VV)
- Yield: 1.93%
- Fees: 0.12%
- 2011-to-date: -6.41%
You may notice that even among these low-fee, large-cap ETFs that there is a significant difference in fees, with variation between 0.06% and 0.4% (or about 6.6 times that lowest fee shown). Additionally, the worst performing of these ETFs so far in 2011 is in fact the one with that highest fee, down over 1% more than the lowest fee option. Interestingly, the best performing listed ETF is the Dow Jones Industrial Average ETF (DIA), which is also the least diverse and highest yielding option.
Nonetheless, all of these fees are considerably below the average fees for a traditional open-end mutual fund, which is above 1% on A-shares (load funds, which also carry an upfront sales charge) and even higher for the C-shares (no-load funds).
Several studies indicate that the majority of funds and fund managers do not outperform the broader markets over the longer term, especially after fees. For example, random walk theory has for decades demonstrated that actively managed portfolios have a low probability of consistently outperforming market averages. Moreover, prior outperformance by an actively managed fund will be increasingly difficult to continue as a fund’s assets grow, and as streaks conclude due to the law of averages. As a result, many professionals suggest that the best course of action for a non-professional investor is to accumulate low-fee indexes over time. Moreover, the recent trend in the ETF business is to lower fees even further, as competition grows.
Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.