Over the last 20 years, ETFs have become more and more popular in part because they are very cheap, often charging management fees that are considerably lower than older investment vehicles. Mutual funds are one of the biggest offenders when it comes to management costs eating into investment returns, and consequently they are losing a huge number of clients to the variety and cheapness of ETFs [for updates on all new ETFs, sign up for the free ETFdb newsletter].
Every strategy has a cost, but investors need to decide before they play what hypothetical return is worth the real costs associated with buying into an ETF or mutual fund. One of the largest and most publicly recognized costs in investing is the expense ratio, which covers a wide variety of the costs that come with owning and operating a fund.
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Mutual funds have to hire and pay fund managers, as well as cover brokerage costs and administrative expenses that come up; all of these fees add up to an average mutual fund expense ratio of around 1.40%. Being cost efficient is one of the most sound pieces of retirement advice you may ever receive, as a few dozen basis points can make a significant difference over the long run [see All Commission Free ETFs].
While it may not seem like a lot, consider $100,000 invested in an all-ETF model portfolio (with an average expense ratio of 0.20%) and another $100,000 invested in mutual funds (with the average expense ratio of 1.40%) over 30 years. With an annual return of 10% a year for both, investors may not notice the difference expense ratios make at first, but after only 10 years it becomes clear just how much more you can make when not wrapped up in management fees. At the end of 30 years, the ETF investor will beat the mutual fund return by over $200,000 [for other great money saving tips, check out the Money Management Center over at Dividend.com].
The rather huge difference among expense ratios is in part due to the automation behind ETFs; everyone can buy into these global funds, most of which run off of a predetermined index and adjust far less often than a comparable mutual fund. Are the high fees worth the returns promised by mutual funds? The Securities and Exchange Commission doesn’t think so, as their website states “higher expense funds do not, on average, perform better than lower expense funds.”
Investors looking for a easy way to switch from the world of mutual funds to ETFs should consider the ETFdb Cheapskate Portfolio as a great starting point. This portfolio is designed for investors who wish to construct a well-rounded, buy-and-hold portfolio for the long haul, while keeping a close eye on expenses [see all 50+ All-ETF Model Portfolios].
Disclosure: No positions at time of writing.