For good and bad, Wall Street is constantly finding new ways for investors to attempt to grow their money. But, with all these products available for investors to choose from and a massive amount of information being presented to the average investor, it is easy to understand why so many investors still ignore ETFs and stick with mutual funds.
In most cases the average investor does not have a choice between a mutual fund and ETFs when it comes to their 401(K) plans through their employer. But for those investors who decide they want to put more money to work than just their 401(K) contributions, plowing more money into mutual funds is a bad idea for three reasons: truly knowing what your buying, performance, and cost.
Knowing What You Actually Own
Walk into any retail store in the US and pick up a any product; find the tag if it's a piece of clothing, the label if it's a drug or grocery item, or even the new Christmas toy you purchased, and you can find out exactly what was used to make that product. Depending on what the product is, there are different laws that have been put in place to protect the consumer which require the manufacturer to inform the customer of exactly what they are getting at all times.
Flip to the world of finance, unfortunately knowing what you are buying at all times is not always the case. While mutual funds are required to disclose their holdings to the public, these disclosures don't typically happen more than on a quarterly or semiannual basis. So what that means is that although you think you have purchased a large-cap growth mutual fund and that the manager must have at least 90% of the fund's assets in large-cap growth stocks, you essentially have no way of finding out if that's really were your money is invested. All the mutual fund manager needs to do is sell whatever doesn't meet the large-cap growth requirement the day before the fund's disclosure statement is put together and to investors it looks like the manager is doing exactly what he is supposed to be doing.
So why would a mutual fund manager not keep the funds in exactly what the fund's prospectus says they will do? Easy, to try to produce a better performance record.
Twice a year the S&P Indices Versus Active Fund report is published and the numbers don't usually favor fund managers. The most recent report released in June 2014 indicated that 60% of large-cap funds underperformed the market over the previous 12 months while 85% of large-cap funds underperformed the market during the prior 36 months. For mid-caps and small-caps the number don't get better, 58% and 77%, 73% and 92%. The figure are not attractive and the point is, mutual funds typically don't beat or even match the market's performance, both in the short or long run.
Now be honest, when you look at your 401(K) investment options or at the statement that comes in the mail every quarter, besides the balance what is the first thing you look at?
The performance of the funds you own. Then you quickly compare those funds which you own to the others being offered by your employer's plan. If your fund is underperforming the benchmark or being blown out by another fund, right or wrong you consider changing.
We all do it and money managers know this!
Furthermore, mutual fund managers typically get paid a percentage of the amount of assets they are managing. Therefore it's in their best interest to keep investors from leaving their fund and attracting new investors. And unfortunately, the way they get paid ends up hurting the investor, because it increases your cost to own the fund.
Mutual funds' cost to the investor vary depending on company managing the money, type of fund, and hundreds of other variables, but it's safe to say the average mutual fund is going to cost an investor around 1% of their invested asset to own that fund. So, each and every year, the mutual fund will take 1% of your money as payment for you to own the fund. That money is used to pay the managers of the fund and other expenses for running the fund. May not sound like a lot, but that's a lot of money.
For example; you have $100,000 invested in a fund for 30 years. To make it easy, let's say the fund is flat over that period of time, it will cost you roughly $30,000 over the 30 years just so you can have your money in that fund. Again, that's a lot of money. But, in reality it would be much more than just $30,000 because your money will likely grow over the 30 year period and as the $100,000 grows to say $110,000 it will now cost you, instead of $1,000 a year, $1,100. The larger the amount you have invested, the more they take in dollar terms.
Lastly, the 1% the fund is taking from you is just the cost of owning the fund. It's not taking into consideration the taxes the fund is paying for short term capital gains or the brokerage fees for the trading activity or any of the other costs associated with the fund. But, for the most part you don't need to worry about the other costs because they will show up simply hurting the overall performance of the fund.
As long as you are buying a standard, non-leveraged ETF, knowing what's in it is rather simple and straightforward. If you buy say the SPDR S&P 500 ETF (SPY), you are buying the S&P 500 and you essentially own all 500 stocks which fall within the index, plan and simple. If you purchase the SPDR Dow Jones Industrial Average ETF (DIA), you own the Dow or if you want more diversity and buy shares of iShares Russell 2000 ETF (IWM), that is exactly what you own, no questions asked.
The only time these funds buy or sell is when the index they follow changes. The S&P ETF has an annual holdings turnover of 2.99%. When the Dow bumped out Bank of America, Hewlett-Packard and Alcoa, so did the ETF, and that's the only time.
Performance is another easy one with an ETF. You own the S&P 500 ETF, want to know how your investment is holding up, check any paper in America or millions of websites and see what the S&P 500 index is doing and you know how you're doing. Simple as that!
As for the cost structure, one may think all of these benefits must have a high cost? Nope. The SPDR S&P 500 ETF is going to cost you 0.09% per year to own, (plus the commission you pay your broker to buy the ETF and any taxes from capital gains). Again, if you have $100,000 invested the first year will cost you $90 per year. Maybe I am just crazy, but that sounds a lot better than $1,000 per year.
When I am asked from the average investor where they should have their money, my rule of thumb answer is always, "keep it simple." Buy indexed ETFs and hold them until you need the cash in retirement. Buying and holding an indexed ETF will not only make it easier for you to understand what you own, but save you money and likely make you more money in the long run.
INO.com Contributor - ETFs
Disclosure: This contributor has no positions in any stocks mentioned in this article. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.