individual stocks.
Table 1-1 ETFs Versus Mutual Funds Versus Individual Stocks
Why the Big Boys Prefer ETFs
When ETFs were first introduced, they were primarily of interest to institutional traders – insurance companies, hedge fund people, banks – who often have investment needs considerably more complicated than yours and mine. In this section, I explain why ETFs appeal to the largest investors.
Prior to the introduction of ETFs, a trader had no way to buy or sell instantaneously, in one fell swoop, hundreds of stocks or bonds. Because they trade both during market hours and, in some cases, after market hours, ETFs made that possible.
Institutional investors also found other things to like about ETFs. For example, ETFs are often used to put cash to productive use quickly or to fill gaps in a portfolio by allowing immediate exposure to an industry sector or geographic region.
Unlike mutual funds, ETFs can also be purchased with limit, market, or stop-loss orders, taking away the uncertainty involved with placing a buy order for a mutual fund and not knowing what price you’re going to get until several hours after the market closes.
And because many ETFs can be sold short, they provide an important means of risk management. If, for example, the stock market takes a dive, shorting ETFs – selling them now at a locked-in price with an agreement to purchase them back (cheaper, you hope) later on – may help keep a portfolio afloat. For that reason, ETFs have become a darling of hedge fund managers who offer the promise of investments that won’t tank should the stock market tank. See Chapter 11 for more on this topic.
Why Individual Investors Are Learning to Love ETFs
Clients I’ve worked with are often amazed that I can put them into a financial product that will cost them a fraction in expenses compared to what they are currently paying. Low costs are probably what I love the most about ETFs. But I also love their tax efficiency, their 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 1.25 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, 6 percent over time. In that case, paying 1.25 percent to a third party means that you’ve just lowered your total investment returns by more than one-fifth. In a bad year, when your investments earn, say, 1.25 percent, you’ve just lowered your investment returns to zero. And in a very bad year … you don’t need me to do the math.
In the world of index funds, the expenses are much lower, with index mutual funds averaging 0.87 percent and ETFs averaging 0.53 percent, although many of the more traditional indexed ETFs cost no more than 0.20 percent a year in management fees. A good number – 122 at last count – are 0.10 percent or less. Some are so low as to be negligible.
Why ETFs are cheaper
The management companies that bring us ETFs, such as BlackRock, Inc., and Invesco PowerShares, are presumably not doing so for their health. No, they’re making a good profit. One reason they can offer ETFs so cheaply compared to mutual funds is that their expenses are much less. When you buy an ETF, you go through a brokerage house, not BlackRock or Invesco PowerShares. That brokerage house (Merrill Lynch, Fidelity, TD Ameritrade) does all the necessary paperwork and bookkeeping on the purchase. If you have any questions about your money, you’ll likely call Schwab, not BlackRock. So unlike a mutual fund company, which must maintain telephone operators, bookkeepers, and a mailroom, the providers of ETFs can operate almost entirely in cyberspace.
ETFs that are linked to indexes do have to pay some kind of fee to Dow Jones or MSCI or whoever created the index. But that fee is nothing compared to the exorbitant salaries that mutual funds pay their stock pickers, er, market analysts.
An unfair race
Active mutual funds really don’t have much chance of beating passive index funds – whether mutual funds or ETFs – over the long run, at least not as a group. (There are individual exceptions, but it’s virtually impossible to identify them before the fact.) Someone once described the contest as a race in which the active mutual funds are “running with lead boots.” Why? In addition to the management fees that eat up much of any gains, there are also the trading costs. Yes, when mutual funds trade stocks or bonds, they pay a spread and a small cut to the stock exchange, just like you and I do. That cost is passed on to you, and it’s on top of the annual management fees previously discussed.
It’s been estimated that annual turnover costs for active mutual funds typically run about 0.8 percent. And active mutual fund managers must constantly keep some cash on hand for all those trades. Having cash on hand costs money, too: The opportunity cost is estimated to be in the neighborhood of 0.4 percent.
So you take the 1.25 percent average management fee, and the 0.8 percent hidden trading costs, and the 0.4 percent opportunity cost, and you can see where the lead boots come in. Add taxes to the equation, and while some actively managed mutual funds may do better than ETFs for a few years, over the long haul I wouldn’t bank on many of them coming out ahead.
Alas, unless your money is in a tax-advantaged retirement account, making money in the markets means that you have to fork something over to Uncle Sam at year’s end. That’s true, of course, whether you invest in individual securities or funds. But before there were ETFs, individual securities had a big advantage over funds in that you were required to pay capital gains taxes only when you actually enjoyed a capital gain. With mutual funds, that isn’t so. The fund itself may realize a capital gain by selling off an appreciated stock. You pay the capital gains tax regardless of whether you sell anything and regardless of whether the share price of the mutual fund increased or decreased since the time you bought it.
