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Are ETFs cheaper than mutual funds?
Exchange Traded Funds, or ETFs for short have enjoyed a major boom in the Canadian market over the last 10-15 years. They’ve gone from a niche investment vehicle to mainstream and are synonymous with two major features: Low-costs and indexing. This article will focus on the first feature, I’ll write a follow-up on the second.
Are ETFs the low-cost king?
The answer ranges from yes to “it depends”. If you’re looking to invest passively in a well know, large-capitalization market like the S&P 500 and you are part of the indexing beats active management clique then yes, ETFs are really the low-cost king. Investing in a major index with ETFs can cost you as little as 6 basis points (or 6% of 1%) in annual fees. This is pretty much negligible and should have almost no drag on your investments over time. So, for those of us who are comfortable building a core portfolio using only big index names like: S&P 500, S&P TSX 60, MSCI EAFE etc. and never straying into anything more fancy then ETFs are really the answer to your low-cost prayers.
But what if you are looking for something other than a big-name index. What if you’re looking for something off the beaten path such as a dividend focused ETF, a preferred share ETF, or a covered-call strategy. Well you guessed it, the costs begin to escalate. In some cases, actively managed ETFs feature Management Expense Ratios (MERs) of 123 basis points (or 1.23%) rivaling the costs of similar F-class mutual funds (the types that don’t pay a commission to your broker). So, if that’s the case your cost savings are anywhere from minimal to nothing at all.
But are costs the only concern?
So, we’ve established the fact that ETFs range in cost from the ultra-cheap to the ultra-expensive. You should also at this point be realizing that checking up on the total cost of ownership must be a major part of your investment due diligence process.
In my opinion, when building out a core portfolio, cost is king. Keeping costs low tends to pay off in the long run. Depending on who you ask and what research you read it is well established that active investment managers fail to beat their respective index on a regular basis (click HERE, HERE, and HERE for a couple examples). This can be due to several reasons.
First, costs can quickly pile up when running an actively managed portfolio. Managers, marketing departments, auditors, and lawyers don’t work for free. These costs will flow out to investors and drag down returns. Second, it is very difficult to pick winning and losing stocks in a well-established index. Think about it, how many millions of investors, analysts, and fund managers worldwide are studying and tracking the companies in the Dow Jones Industrial Average. It is almost impossible to consistently pick a portfolio of winners year over year when so many people are acting on the same publicly available information. Third, closet indexing. Because manager’s performance is often compared to a reference index many managers tend to design portfolios that “hug” their index. By designing portfolios that mimic the performance of their index, managers can play it safe by at least matching the performance of their index without falling short.
But what if your only goal is not to develop a so-called “core” portfolio. In cases such as these where an investor would like additional exposure to a particular sector of the economy, perhaps by investing in an infrastructure fund, or gain exposure to preferred shares without incurring company specific risk (which would be the case if you only invested in one company’s preferred share) then drifting into slightly higher-cost ETFs may be unavoidable but actually still beneficial. Specialty ETFs, those that invest in off-the-beaten-path strategies can still provide excellent diversification to a portfolio or achieve a specific goal albeit at a slightly higher price.
Like anything in life there is a tradeoff between price and uniqueness and the ETF industry is no exception. While ETFs can provide some very inexpensive exposure to major markets, they are by no means all inexpensive. ETFs can range greatly in price from negligible to very expensive and even rival the costs of more traditional mutual funds. However, with a bit of research, ETFs can still provide reasonably priced exposure to many markets along with instant diversification and simplicity in building a portfolio.
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