Cost Advantage of Exchange-Traded Funds - dummies

By Russell Wild

Some of the many advantages of exchange-traded funds (ETFs) include low costs, tax efficiency, transparency (you know what you’re buying), and the long track record of success for indexed investments.

In the world of actively managed mutual funds (which is to say most mutual funds), the average annual management fee, according to Morningstar, is 1.33 percent of the account balance. That may not sound like a lot, but don’t be misled.

A well-balanced portfolio with both stocks and bonds may return, say, 7 percent over time. In that case, paying 1.33 percent to a third party means that you’ve just lowered your total investment returns by about one-fifth. In a bad year, when your investments earn, say, 1.33 percent, you’ve just lowered your investment returns to zero.

The average charge for mutual funds is 1.33 percent, but charges have been as high as 10 times that amount. Crazy. Investing in such a fund is tossing money to the wind. Yet people do it.

The chances of your winding up ahead after paying such high fees are next to nil. Paying a load (an entrance and/or exit fee) that can total as much as 8.50 percent is just as nutty. Yet people do it.

In the world of index funds, the expenses are much lower, with index mutual funds averaging 0.64 percent and ETFs averaging 0.50 percent, although many of the more traditional domestic indexed ETFs cost no more than 0.20 percent a year in management fees. A handful are under 0.10 percent.

Some fees are so low as to be negligible. Each ETF shown here has a yearly management expense of 0.12 percent or less.

ETF Ticker Total Annual Management Expense
Focus Morningstar U.S. Market Index FMU 0.05%
Focus Morningstar Large Cap Index FLG 0.05%
Schwab U.S. Broad Market SCHB 0.06%
Vanguard S&P 500 VOO 0.06%
Vanguard Total Stock Market VTI 0.07%
Schwab U.S. Large-Cap SCHX 0.08%
SPDR S&P 500 Index SPY 0.09%
iShares S&P 500 Index IVV 0.09%
PIMCO 1–3 Year U.S. Treasury Index TUZ 0.09%
Vanguard Large Cap VV 0.12%
Vanguard Short-Term Bond BSV 0.12%

Numerous studies have shown that low-cost funds have a huge advantage over higher-cost funds. One study by Morningstar looked at stock returns over a five-year period. In almost every category of stock mutual fund, low-cost funds beat the pants off high-cost funds. Do you think that by paying high fees you’re getting better fund management? Hardly.

The Morningstar study found, for example, that among mutual funds that hold large blend stocks (blend meaning a combination of value and growth . . . an S&P 500 fund would be a blend fund, for example), the annualized gain was 8.75 percent for those funds in the costliest quartile of funds; the gain for the least costly quartile was 9.89 percent.