By Ryan Bouchey, CFP, CPA
As an investor there are an endless number of investment options at your disposal whether it’s through a broker, your advisor or if you are investing on your own.
Over the past 20 years, for many investors, their primary investment vehicle has been mutual funds and according to the Investment Company Institute, total assets invested in mutual funds at the end of 2012 was over $13 trillion.
Exchange Traded Funds (ETFs) were developed in the early ’90s to provide investors with an efficient and transparent way to access asset classes through the use of an index and not active management. Although still small relative to mutual funds, in recent years the growth in ETFs has been tremendous with total assets of $1.3 Trillion in 2012. Here are five reasons to consider using an ETF over an actively managed mutual fund:
1) Performance – This is generally what gets evaluated first by any investor and what typically drives an investment decision. According to the S&P Indices Versus Active Funds U.S. Scorecard, in 2013, 56 percent of large cap mutual fund managers under performed their benchmark and 68 percent of small company managers failed to beat their benchmark.
If you look at three-year and five-year return intervals, these numbers increase even higher, with 65 percent to 85 percent of managers underperforming their benchmark. By investing in an ETF you are investing in an index that mirrors these benchmarks which overtime frequently outperform actively managed mutual funds.
2) Fees – The average ETF annual fee is currently 0.58 percent versus 1.24 percent for the average open-end mutual fund per data compiled by Morningstar. One of Bouchey Financial Groups core holdings, Schwab US Large Cap ETF (SCHX), has an annual fee of 0.04 percent.
This investment tracks the S&P 500 index which most active managers were unable to outperform in 2013 while you pay them in some cases more than 1 percent more in annual fees. Over time these excessive fees can begin to negatively impact the performance of a portfolio.
3) Full Transparency – Acting as a fiduciary for our clients, we are constantly stressing the importance of “full transparency” in investments and it is a big reason we like ETFs. Because many ETFs track an index, you can always tell which investments will be included in an ETF. You may be investing in an ETF that tracks the S&P 500 (Large Cap US Equities) or the Russell 2000 Index (Small Cap US Equities).
You know that the investments will be made up of either US large cap companies or US small cap companies, respectively. When investing in a mutual fund, at the time it may have a strategy in place to be a US large cap mutual fund. Over time however, the investment manager may begin buying more mid-cap stocks which would stray from the original strategy. In this case, you really would not be receiving what you signed up for when you made the initial investment.
4) Lack of Share Classes – When investing in an ETF, there is no need to determine which share class is best for your strategy. ETFs come in only one type of share, and fees for an ETF will include your annual expense ratio as well as a potential transaction charge. These fees are straightforward and you will have full clarity as you make your investment decision. When it comes to mutual funds, in additional to the annual expense ratio you have the choice of Class A , B and C shares and perhaps an Institutional Share class.
Each class comes with a different set of fees on top of the expense ratio. You may have a front-loaded fee in your Class A share, a Class B share will be back-loaded with a deferred sales charge which may change based on how long you hold onto the investment, and a Class C share will have a more level-load throughout the investment. With mutual funds there are also the trading fees of the manager and 12b-1 fees which can impact the long-term performance of the fund. For the average investor, these fees are difficult to navigate and can change depending on your time horizon for holding the investment.
5) Macro Approach – Since an ETF tracks an index, many times we invest in an ETF because we like a specific asset class. For example, right now our firm holds the Powershares QQQ which tracks an index of 100 NASDAQ listed stocks giving us exposure to technology stocks in a diversified manner.
To illustrate the benefit of this approach versus buying individuals stocks, assume you had to choose between investing in Microsoft or Apple in the early 2000’s. Both companies are great companies with growing profits and revenue but Microsoft would have been a poor investment while Apple would have grown substantially. By using an ETF we mitigate the risk of choosing the wrong stock while over time giving us a higher risk-adjusted rate of return.
Bouchey is vice president and CFO of Bouchey Financial Group Ltd.
Photo Courtesy Bouchey Financial Group Ltd.