Many of you know that one of the classes that I TA is a portfolio theory and practice class, where students learn the how and why of constructing mean-variance efficient portfolios for investors. As part of the class students are expected to put together a final project that involves constructing an investment plan for a client that is mean-variance efficient. I’ve taught the class a number of times now. My experience is that students seem to come to believe the core lessons of the class, to keep expenses low, diversify, invest in asset classes rather than picking individual assets, and to distrust alpha (investment managers who claim to have the ability to outperform markets without taking exotic risks).
One place where students often end up taking a different position than I do is exchange traded funds (ETF). They like them because they see them as having ultra-low fees. ETFs performs similar to a mutual fund but you buy and sell it on the stock market rather than from a mutual fund company. As such, you generally pay a a brokerage fee to buy it and again to sell it. Many people don’t know that you also pay annual fund operating expenses, just like a mutual fund.
For example, SPDRs perhaps the most liquid and popular exchange traded fund in the world have an .09% annual operating expenses. That’s 9 cents on each $1000 invested per year. In contrast, the Vanguard 500 Index charges 0.18%, Fidelity Spartan 500 Index charges 0.10%, and the Schwab S&P 500 Index charges the same 0.09%. Yet all three of these funds track the same underlying portfolio, a market weighted portfolio of the 500 largest publicly traded US corporations with little tracking error. So even you didn’t have to pay to trade ETFs, it would take a long time to make an economic difference. Say after fees and inflation you can get 7% on the SPDR and 6.99% on the Fidelity Spartan. To make things simple we’ll ignore reinvestment issues (which advantages mutual funds, more on this later) and just assume we can annually compound your investment of $10,000 at the two rates. After 30 years you’ll have (on average) $75,909 with Fidelity and $76,122 with the SPDR ETF. That’s $213 extra for your troubles.
What troubles? Mutual funds typically allow you buy and sell them without and fees (if has fees for this you probably should get one that doesn’t) where as ETFs have fees to pay in both directions, plus bid ask spreads (which are small but still count). Call that $8 on each side (buying and selling). Now the ETF advantage over $30 years is down to $144.65 per $10,000 initial investment even without the reinvestment issues.
Also, unlike the stock market you can buy fractional shares. As of right now, SPDRs trade for $109.82 each. So if you have $439.28 to invest you are all set. On the other hand, if you have say $500 to invest, you can buy $439.28 worth and then save the remainder until you have enough to buy another share. In a mutual fund they’d happily sell you 4.55 shares. Similarly, this is a problem for reinvestment. when you get a bunch of dividends in a mutual fund you can buy .25 more shares, which in the ETF you have to wait in some way until you have enough to buy a share. Which means that you are not fully invested in the stock market as you intend to be and over the long haul you get a lower return. Obviously if you have a lot to invest this isn’t a huge deal. You’ll get approximately one share in quarterly dividends for each $22,000 you invest. Fractional investments mean uninvested money. But, you have to pay that trading fee on reinvesting those dividends (unless your have a decent drip program which you can’t always get and I believe generally can’t with ETFs) , so you end up with much higher total expenses because you end up paying $8 every time you have dividend. At $32 in reinvestment fees a year it only takes a few years to eat up that lower fee. Over that 30 year investment from before, the break even is now about $70k. Any less than that and you make out better with the mutual fund even ignoring univested capital.
Finally, if you ever work for a bank or financial firm they are going to want you to put your money into their brokerage system. Chances are when they do it will be a full fee brokerage, charging a great deal more than $8 a trade. So the economics get even worse if you work in finance or consider a full fee broker over a discount one.
My closing advice is that in general one should invest in a series of index funds that expose you to your desired asset classes, and reinvest the dividends and interest. This is a relatively low cost, liquid, and simple financial plan that mostly takes care of itself except for the occasional re-balancing issues that also exist for an ETF strategy except that they are more expensive in that case.
