An exchange-traded fund (ETF) is an investment fund traded on a stock exchange. 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.
This is a comparison of several broad market low fee ETFs. Each of these ETFs has an expense ratio below 0.4% and a considerably broad portfolio of holdings, with several numbering in the thousands. I have also included the Nasdaq 100 ETF (QQQ), which is less extensive of a basket, but a very popular and eclectic basket of stocks. I have provided each ETF’s expenses and current dividend yields, as well as their 2011-to-date performance.
These 0.4% or lower 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). Low fees can make a huge difference over time. For example, a $10,000 investment in a product with a 1% management fee will be charged $100 in fees that first year. 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. If the investment went nowhere for 10 years, the difference between a 1% and 0.4% fee would be about 6%.
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 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.
iShares Dow Jones U.S. Total Market Index ETF (IYY)
iShares Russell 3000 ETF (IWV)
iShares S&P 1500 ETF (ISI)
PowerShares FTSE RAFI U.S. 1000 ETF (PRF)
PowerShares QQQ Trust (QQQ)
Schwab US Broad market ETF (SCHB)
Vanguard Total Stock Market ETF (VTI)
The 3-month chart, below, shows that much of QQQ’s outperformance has occurred more recently. Since June, the broad market ETFs are all down at least 7%, while the Nasdaq 100 portfolio is slightly positive.
In fact, several studies indicate that the majority of funds and fund managers do not outperform the broader markets, 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.