In thinking about this blog post I considered writing about “investment containers.” People will often say “I have mutual funds”, “I have an IRA”, “I have a 401(k)”. Which is like saying “I have a brown box with stocks and bonds in it”, “I have a yellow box with stocks and bonds in it”, or “I have a green box with stocks and bonds in it.”
These are all really containers for your investments, and each has different rules for how you put money in and take money out. Let’s look at the famous mutual fund, and a great alternative.
Mutual funds, as we know them today, really began in the 1940’s. For a long time if you wanted to diversify, the basic choices were: buy a mutual fund, or allow a broker to maintain a portfolio for you. If your choices were to pool money with a large mutual fund run by the best and brightest in the industry, or allow the twenty something broker to make these decisions, the answer was pretty clear.
Over the decades mutual fund companies flourished and became massive, and most brokerages essentially became the sales arm of the fund companies. While brokerages were still happy to trade stocks for you, they were just as happy to sell you mutual funds. As you can imagine, a lot of people need to be paid for all of this. The mutual fund company and it’s operations, the brokerage and it’s back office, etc… And, the broker has to make what would have otherwise been earned trading stocks for you.
As a result, mutual funds can be a very expensive way to invest. For example, most clients of a large broker or advisor may be placed into “loaded funds” with a variety of sales charges and ongoing annual fees. For example, a 5% sales charge is not uncommon, which means it takes a 5% return just to get back to your initial investment. Ongoing management fees can run between 0.5% and 2%, these last forever. And then there is a thing called a 12b-1 fee (named after a rule) where the fund can charge you a separate fee to advertise itself, seriously.
Along the way, mutual funds realized they could sell “no-load” funds. These have no sales charge, and generally cater to the “do it yourself” investor. While the ongoing fees can still be high it was a big leap for people who didn’t need the “advice” of a broker. Over the years firms like Vanguard have been able to make “no-load” funds quite inexpensive.
The Exchange Traded Fund
In the late 1990’s a new option began to appear. The exchange traded fund is a portfolio of stocks that trades on the open market as a trust. The trusts are created by issuers, and cover just about every asset class an individual investor would ever need. The great thing about ETFs is that they can be very inexpensive. The most popular ETF that owns the S&P 500 charges a mere 0.09%. Why would you pay a 5% sales charge and ongoing annual fees pushing 1% to a mutual fund company when you can own the same exact stocks for 0.09%?
If you’re thinking most brokerages are putting clients into mutual funds instead of ETFs because it makes them more money, you would be absolutely correct. They will have a lot of answers as to why the mutual fund in better, and these can sound very convincing.
For example, a mutual fund can be “active,” which means trading a lot while trying to beat the market, or “passive,” which means they’re happy to take the long term returns of a stock index, like the S&P 500. Your broker or advisor may highlight how a mutual fund “always beats the market.” Statistically, this can sometimes be true for one or two years, but it’s been proven that over the long run, they have a 50% chance, meaning they’ll do worse 50% of the time.
Most of the time these active managers “hug” the index, meaning they basically own the index, but make a few active choices to justify the fee and try to beat the index. Often, you’re just paying a lot to basically own the index.
Another way around this is where a firm will bundle low cost ETFs into portfolios they sell as a “managed account”. They purchase a bunch of ETFs, and then slap their own management fee on top of the portfolio of ETFs. Seriously.
Avoiding the Fees
The ETFs are out there waiting for you with lots of choices: super conservative, super risky, very boring, highly exotic, and everywhere in between. I look at them as tools in a tool box. If you’re comfortable managing your own investments you might want to consider moving into ETFs if you haven’t already.
If you’re someone who likes to engage a professional to help manage your financial life, you can work with a truly independent investment advisor, like Buoyant Financial, where we build portfolios using ETFs to save our clients’ money, and because it’s the right thing to do.