ETFs vs. Mutual Funds: Why Investment Fees Matter

We’ve been taught since we were kids that it’s not what you make, it’s what you keep. This statement couldn’t be any truer when it comes to investing. We all know that nothing is free, and if you want professional advice it will cost you something. However, there are things you can do to keep your costs down and still receive expert advice.

Most investors are familiar with mutual funds either through their 401(k) plan or their brokerage accounts. Mutual funds have been around for a long time and have been part of investors’ holdings for a long time. However, with the evolution of the investment business, exchange-traded funds (ETFs) have garnered more and more attention. Why? Because they offer similar diversification benefits as mutual funds but with significantly lower costs. (For more, see: Mutual Fund or ETF: Which is Right for You?)

According to the Investment Company Institute's (ICI) 2016 ICI Annual Report, as of June 2016, U.S. ETFs had $2.2 trillion in assets compared to $423 billion in assets at the end of 2006. This shouldn’t really surprise anyone given the amount of information available to investors today. Investors are becoming much more aware of costs, opportunities and flexibility. ETFs not only offer lower costs, but their expansion into different asset classes gives investors the flexibility to buy and sell ETFs just like they would any individual stock. Add to this that firms like ours are using ETFs to provide low-cost alternatives for our clients, and you can see the growth of the ETF industry will continue for some time. That being said, mutual fund assets still dwarf ETF assets and many advisors continue to use mutual funds for their clients.

The Savings Add Up

So how much can you realistically save by replacing your mutual fund holdings with ETFs? In short, a lot. According to ICI, mutual fund expense ratios have declined since 1996, but they still exceed that of ETFs. While the decline in mutual fund expense ratios is a welcomed event, they still haven’t reached the level of ETFs.

You may be thinking that these differences are fairly negligible, and you may also believe the added cost of mutual funds will be off set by performance. I’ll deal with the performance issue later. First, let’s keep in mind that the above numbers are averages. There are many mutual funds with expense ratios as high as 2%. There are also many ETFs that have expenses as low as 0.03%. But let’s use what we have. Let’s say you’re a 50/50 investor (50% stocks, 50% bonds). Using the above numbers, here is the comparison of costs between a mutual fund only and ETF only portfolio:

The savings of 0.41% each year may not seem like a lot, but it adds up over time. Assuming you have a portfolio value of $250,000 and plan to invest for 30 years, you would be sacrificing $32,650 at the end of that time. (You can find additional calculators here.)

Since most investors aren’t invested in average cost mutual funds or ETFs, let’s say your mutual fund is charging you 1.25% and the ETF is charging 0.05% giving you a savings of 1.20%. That same $250,000 portfolio over 30 years would result in $107,565 of additional growth. (For more, see: Using ETFs to Build a Cost-Effective Portfolio.)

The reason for such accumulation is the power of compounding over the years. Every little bit helps when it comes to building your retirement nest egg. If you’re working with an advisor, ask him/her what underlying expenses you are paying. If you’re doing it alone, call the fund company. It’s your money and you deserve to know.

Added Costs Don’t Translate into Performance

Many investors think mutual funds should outperform since they are charging more. Unfortunately, that is not the case. Obviously, costs matter and can be a drag on active mutual fund managers, but the competition for individual stock picking has also picked up significantly over the last few decades. So, if active mutual fund managers are challenged to beat their benchmarks, why pay the additional expenses?

Tom Rampulla, Managing Director at Vanguard Financial Advisor Services, wrote an article called Why Is Passive Winning? In the article, Rampulla stated, “We took a look at what investors paid active managers over the last decade at the end of 2015 - $437 billion.” He went on to say, “What did they get? Those active managers underperformed the indexes by $545 billion.” If you take into account the cost of the mutual funds and the underperformance, investors have sacrificed nearly $1 trillion in that decade alone.

Rampulla went on to state in the article that only 16% of active managers outperformed in the U.S. large-cap space, 32% in emerging markets, 14% in high yield, and 36% in U.S. small-cap equity. These are very challenging numbers and is another reason for the impressive growth of ETFs.

Clearly, not all active mutual fund managers will underperform. However, it is important for investors to understand how much they are paying for these mutual funds and determine whether they are really getting something out of it. If not, there are alternatives.

With the growth of the RIA model, many qualified investment managers have made the transition from institutional management. Firms like ours are delivering low-cost alternatives to clients leaving them with more in their pockets. We cannot control what the markets will do, but we most certainly can control how much we pay for our investments. (For more from this author, see: Investing Basics: What You Need to Know.)

 

Disclaimer: This article is for educational purposes only. Investments involve risk. You should consult a financial professional before investing.