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Mutual Fund Owners: Should You Switch to ETFs?

Less in fees means more remains in your account, but don't overlook outperforming managed funds.

08/01/2012

Regardless of how well or poorly the overall stock or bond markets perform, you can come out with more if less in fees are being deducted from your account balance. But few investors likely have a sense of exactly how costly fund investment fees can be to the long-term investor. If, for example, your funds’ expenses average what appears to be a “mere” 1% a year, and you have $50,000 invested altogether, you are paying $500 each year out of your accounts to own these funds. Over longer periods, the payment of these fees mean that the amount lost to fees grows greater since each $500 would keep compounding if it had remained in your account.

In this article, I will discuss not only the huge effect fees can have on success as an investor, but also the potential importance of hitching your wagon to a fund that can potentially outperform even after fees are taken into consideration.

Are ETFs the Answer?
In recent years, there has been a tremendous amount written about why mutual funds are no longer considered to be attractive while ETFs (Exchange Traded Funds) are. But are ETFs really better than traditional mutual funds as is frequently purported? I have devised guidelines for whether, looking forward, it no longer pays to buy funds but rather ETFs instead, and if one already has funds, whether to move them to ETFs.

I wish there were simple answers. But as you will see, there aren’t. However, there are some rules of thumb you can use to determine whether you should continue to hold your funds or whether you should consider looking for and switching to comparable ETFs, since one of the main claims made for ETFs is the notion that ETFs are almost always lower in cost. If true, other things being equal, lower costs should mean higher returns since you get to keep more of what the underlying investments earn.

But, in reality, another possibility is merely trying to find and possibly switch to comparable mutual funds with costs as low or maybe even lower than some ETFs; surprisingly, some do exist. Of course, all of this assumes you do have the possibility of switching into comparable low cost options since perhaps your choices are restricted, such as within many 401(k) plans.

Honestly speaking, in recent years there has been a tremendous amount of hype surrounding ETFs. For example, here is what I found on a website that is obviously geared toward pitching to the ETF investor: “For all the benefits exchange traded funds (ETFs) offer, it’s little shock that they’re trouncing mutual funds in nearly every regard.” Such a statement shows not only the writer’s bias, but ignorance as well. In reality, there is often very little or no bottom line advantage for owning many ETFs over comparable mutual funds.

The largest ETF, the SPDR S&P 500 ETF (SPY), has returned 5.2% over the last 10 years (through 6-30-12). But so has the very low cost Vanguard 500 Index Fund (VFINX). So where was the advantage?

Since many index funds often (but not always) wind up doing better than managed funds of the same fund category, then perhaps the whole spectrum of index funds should be higher within investors’ priorities vs. comparable managed funds. But when low cost index funds are matched head-to-head with similar ETFs, one can find little evidence of the performance superiority of the latter. And, even when costs are lower, are they really significantly lower enough to justify switching out one’s mutual funds to such lower cost options?

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