August 15, 2017 | by James Behr Jr
Imagine you are driving down the road and notice the much-dreaded gas light is blinking on your dashboard. You pull up to an intersection and spot a gas station on the left, advertising a price of $2.75/gallon, and another gas station on the right, with an advertised price of $2.45/gallon. Which way do you turn? The answer is obvious: turn right. Any rational decision maker would not have to think twice about choosing the station that will cost them less to fill up their tank. Unfortunately, many investors make the mistake of turning left in their investment decisions and end up paying a substantially higher price for a fund that has a much cheaper alternative.
Bloomberg analyst, Eric Balchunas, recently shed light on this issue in the current market for mutual funds by tweeting a screenshot of a Bloomberg terminal displaying market data corresponding to fifteen mutual funds. Balchunas’ tweet (pictured below) shows that people are investing their money in funds that are charging them expense ratios from .25%, all the way to an outrageous ratio of 1.34%. An expense ratio is the annual fee that funds charge their shareholders and is the percentage of assets deducted per year for fund expenses, including 12b-1 fees, management fees, administrative fees, and other operating expenses. This essentially means that the higher the expense ratio, the more money is taken from the pockets of investors and delivered to the pockets of those firms and fund managers.
While no one would argue that the .25% expense ratio corresponding to the USSPX is a much better ratio than the 1.34% ratio that is offered from SPIBX, these numbers are still incomparable to the incredibly low ratios offered by exchange-traded funds; securities that track an index, but are traded on the exchange. The chart below shows up-to-date data on the above mutual funds and compares them to the Schwab US Large-Cap ETF with an expense ratio of only .03%.
Mutual funds and ETFs have similarities that, for the most part, allow the two fund types to be considered alternative investments; both offer low risk via diversification and professional management to ensure each fund’s basket of securities are skillfully handled. This means that the decision of which to pursue should then come down to the cost associated with each, and while there are various differences between ETFs and mutual funds that investors should be aware of, ETFs are generally less costly than mutual funds.
Mutual funds are structured to charge transparent fees (load fees) on top of the high non-transparent fees (expense ratio). A load fee is a sales charge that investors pay when buying or redeeming shares in a mutual fund. The chart below displays a column containing the load fee for each fund, these of which have not been included in the expenses and savings calculations. Therefore, you can expect to pay an even larger amount in expenses than shown below for those funds carrying a load. ETFs do not pay a load fee, but are subject to commission fees (which vary by firm and are typically negotiable), as well as their relatively low expense ratio. In fact, the aforementioned Schwab ETF has a 0% commission fee, leaving the .03% expense ratio as its sole expense. These structural differences between the two vehicles give ETFs a rather consistent cost advantage over mutual funds, and thus benefit investors by not taking away from performance.
For example, in the first row of the chart below, a total of $1.1 billion assets are invested in the Invesco S&P 500 Index B Fund with a 1.34% expense ratio, costing shareholders $14.74 million in fees alone. If those same assets were instead invested in the Schwab ETF with the .03% ratio, shareholders would only pay out $330,000 in fees, saving them a whopping $14.41 million per year! This simple calculation, which is shown for the other remaining funds in the last column, makes it evident that investors would be far better off investing in the Schwab ETF than any of the mutual funds listed below.
So, should one always invest in ETFs over mutual funds? Not necessarily. Both products provide diversification and can enhance the returns of a portfolio when utilized correctly. However, understanding the structure of each fund type, and more importantly, researching all of your options and not simply falling subject to the pitch of a great salesman, ensures that you will not turn left and pay $2.75/gallon to fill up, when there is a much cheaper alternative right around the corner.
If you would like a complimentary review of the funds in your portfolio or to learn more about how our team at Blue Bell Private Wealth Management may be able to help you plan for your financial future, please contact us at email@example.com or call us at (610) 825-3540.
Thanks to our intern Alyssa Dodson for her contributions to this writing.