On Exchange Traded Funds – Something All Investors Should Own

By Kevin Powell

Investors have a myriad of investment choices for their portfolio. Stocks, bonds, mutual funds, ETF’s, options, futures, currencies, fixed annuities, variable annuities, real estate, REIT’s, private placements, CD’s, T-Bills and on and on. It’s a lot to keep up with as a full time professional let alone someone trying to manage their lifetime savings.

There are a couple of key reasons why ETF’s should be a part of your portfolio. First, they offer key management opportunities that mutual funds don’t. One of those is that you can buy and sell your ETF at any time the markets are open. You can’t do this with mutual funds. Mutual funds are priced at the end of the day. To process an order, you must place it before 2 p.m. EST. If you place your order after 2 p.m., your trade won’t take place until the close of business the next day.

You can place what is known as a stop/loss order with an ETF. Assume you’ve got a sizable capital gain in an ETF. You don’t want to sell too soon but you also don’t want a sudden sell off in the markets to rob you of all your profits. You can put an order to sell your ETF and protect some of your profits if the worst happens. Suppose your ETF was worth $75 and your average cost was $30. You could place a stop/loss at $60 and protect that other $30 profit in your ETF.

If the price dropped to $60, your ETF would be sold at the next sales price. With a mutual fund, you’d likely have no option other than to place an order that might not be filled until the close of the next trading day.

Mutual funds have a myriad of fees. There can be a sales charge (A shares); deferred sales charge (B shares) where if you don’t own that company’s funds for many years, you’ll pay a fee; or there can be a contingent sales charges (C shares) where the company charges an average of 1percent on your account over a period of years.

Then there are the disclosed fees. For stock funds those averaged from 1.5 to 2.5 percent in 2010. Bond mutual funds had disclosed fees of about 1.1 percent. There are 12-b-1 fees or advertising or distribution fees. These are usually a quarter to half percent per year.

One of the biggest hidden fees with mutual funds is trading fees. The more trading or turnover in your fund, the higher your trading cost. The average trading fee was about 1percent in 2010. Is your wallet hurting yet?

Estimates are that mutual funds cost investors from 2 to 3 percent annually and that’s just the cost of owning the shares. That doesn’t include service on your account in many cases. ETF’s have an average expense ratio of 0.15 percent. Think about it. If you invested $1,000 into an ETF, you’d pay about $1.50 a year in fees.

For the right to own a typical mutual fund, that cost could be closer to $30. It doesn’t seem like much money in that scenario, but if you save money over 20-30 working years, the cost difference will be in the tens or hundreds of thousands of dollars. That’s money you won’t have for your retirement!

ETF’s are seeing a pricing war as more and more investors are learning about these differences and companies are fiercely competing to retain and attract new investors. The latest round of cuts came from BlackRock. They cut the fees on their core S&P 500 Index ETF to 0.07 percent. That’s seventy cents per $1,000!

In September, Charles Schwab went after the decade’s low cost leader Vanguard. Schwab reduced their fees to 0.04 percent on its S&P 500 ETF compared to Vanguard’s fee of 0.05 percent on its flagship S&P 500 fund. The good news for Vanguard investors is that they lower fees even further as your account balance increases through the years.

Vanguard likes the moniker of being the low-cost leader and announced that starting in Jan. of 2013, they were reducing the fees for their 22 largest ETF’s to even lower levels. So the war is on.

Not to get too confusing but there are hidden expenses with ETF’s also. For example the Schwab US Broad Market ETF costs 30 basis points more to purchase than to sell. That’s called a spread.

By the same token, Vanguard’s spread on their similar ETF is 10 basis points. There are many on-line calculators you can use to see this cost illustrated. One we ran was for a portfolio of $250,000 held for 15 years with no sales charges or redemption fees. An average expense ratio of 2.5% annually in a mutual fund wound up costing the investor $141,000 over those 15 years.

An ETF with a 0.15 percent expense ratio in the same example cost only $1,106! That’s one hundred and forty thousand reasons why you should consider ETF’s versus mutual funds. This is one of the most serious mistakes that investors make with their savings. At the start of 2012, there was roughly $24 trillion invested in mutual funds. Out of that, $11.6 trillion was invested in U.S. funds. U.S. ETF’s had a little more than $1 trillion in assets or about 90percent less than mutual funds.

Retirement plan make up about 75% of all mutual fund assets. Can you imagine how much more money households would have if just half of all retirement plans switched to ETF’s? Want to give the economy a huge boost? Put all the money that’s going to mutual fund expenses into the hands of individual investors who will in turn spend it at our local merchants, buy more appliances, cars and on and on.

Financial Advisor Kevin Powell can be reached at kpplanner1@gmail.com

Kevin Powell has been a financial advisor for the past 27 years working with clients and businesses nationwide. If you have any comments, contact kpplanner1@gmail.com.

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