At this point in the life cycle of ETFs, most investors know that one of the primary reasons ETFs were created was to provide investors with a more liquid, lower-cost alternative to mutual funds. Having spent several years analyzing, researching and trading ETFs, I get the feeling that mutual fund companies didn't pay much attention to ETFs when ETFs were in their infancy.
I have this vision in my head of a bunch of guys in blue suits, white shirts and boring ties sitting around a desk at Fidelity, John Hancock or T. Rowe Price circa 1997, a few years after the SPDR S&P 500 Trust started trading, laughing at ETFs and never thinking of this new asset as anything more than an annoying younger sibling that would never truly threaten the dominance of mutual funds.
Boy, were those guys wrong! At the end of last year, mutual funds managed some $18.7 trillion in assets. ETFs will probably pass the $1 trillion mark this year, so they have a long way to go before really usurping mutual funds. Mark my words: That day will come. There are several reasons why ETFs are superior to mutual funds. ETFs trade like stocks, so they are more liquid. Mutual funds only trade at one price per day, the fund's net asset value. In other words, mutual funds are not trading vehicles, but ETFs accommodate both the active trader and the long-term investor.
You can trade ETFs on margin (I'm not saying you should, in fact, you should not). You can short ETFs, but you can't short mutual funds. Many ETFs are also optionable, but options cannot be traded on mutual funds. A variety of order types can be used to purchase and sell ETFs (market, limit, etc.) That is not the case with mutual funds.
There are several more reasons to consider dumping your mutual funds in favor of comparable ETFs, but I'm going to talk about only more and that is the most important reason: Cost. Mutual funds are a real minefield when it comes to small fees that can really add up to take a toll on your overall returns. Many mutual fund companies know that investors have become more savvy over time and the fund issuers have taken some admirable steps to lower fees.
Even with that, investors can usually expect 1.5% of invested capital to be immediately lost to fees when investing in a mutual fund and that does not include any redemption fees which some mutual funds charge when you want to sell your shares. Nor does that include the commission paid to to buy the shares.
Mutual funds wrap their fees into what they call the expense ratio, which is based on the management fee, administrative costs and the 12b-1 distribution fee. The management fee pays the fund manager and can be as high as 1%. Administrative costs include customer service and issuing prospectuses and these costs could run as high as 0.4%. The 12b-1 fee is the one that will really irk you because this what a mutual fund issuer charges you, the current investor, to attract new investors via advertisements, etc.
Let's assume that you find a mutual that tracks the S&P 500 that has the highest expense ratio possible using the numbers that I used above. That's 2.4%, meaning if you invest $100,000 in this mythical mutual fund, you're out $2,400 right off the bat. If there's a front load fee of 0.5%, basically a fee for the privilege of buying your shares, and a redemption fee of 0.5%, there's another $100 out of your wallet.
Now your $100,000 is down to $97,500, meaning this mutual fund needs to rise by 5% just to give you a profit of 2.5%. Simply put, that scenario stinks, but its easily avoidable. SPY, the biggest ETF in the world by assets and the most popular one that tracks the S&P 500, has an expense ratio of just 0.9%. Take a look at the chart below. The savings with ETFs can be seen across plenty of different funds, including growth, bonds and emerging markets.
The frugal investor can go a step further and select the iShares S&P 500 Index ETF (NYSE: IVV). IVV is essentially the same type of offering as the SPDRs (NYSE: SPY) and both have the same expense ratio, but you can trade IVV commission-free if you're a Fidelity client.
You heard me right: Several brokerage firms offer commission-free trading on ETFs. Fidelity offers 25 iShares shares commission-free. Schwab clients can trade that firm's ETFs free of charge though Schwab currently offers less than 15 ETFs. Even more impressive is the fact that Vanguard clients can trade all of that firm's ETFs for free. I say more impressive because Vanguard offers close to 50 ETFs.
Take my word for it: Costs matter in investing. There is simply no reason to be making needless donations to the mutual managers of America when it can be avoided. Opt for ETFs over mutual funds because the money belongs in your wallet.
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Global Profits Alert (GPA) is published by Trippon Financial Research, Inc. a financial media organization with offices in the United States, Hong Kong and Mainland China. GPA is written by Jim Trippon in conjunction with George Wolff, Sunny Wang, Todd Shriber, Kelley Damiani and J. Daryl Thompson.
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