Investors have much to gain from the recent frenzied competition in the ETF and Mutual Fund market places. Lower costs are unambiguously good for investors.
As a review, both mutual funds and ETFs provide investors with a wide diversification in a highly regulated environment with liquidity and transparency. There are differences between ETFs and classic mutual funds, but the dramatically lower cost of both are driving a sea change in how smart investors allocate their funds.
The ETF is and will be a disrupter to the traditional fund and asset management industry as it gobbles up market share like Pacman on steroids. In just 24 years since the first ETF, the SPDR S&P 500 was introduced assets swelled from zero to $4.5 Trillion with $3.1 Trillion in the US alone. And assets are growing at an astounding rate, up 70% in the last three years.
The link between low fees and higher performance is very straightforward. Additionally, it’s clear beyond a reasonable doubt that the myth of higher performance of actively managed funds is unsupported by fact. Across the board actively managed funds have lower performance, higher tax burdens, and higher risk than a passive index type fund.
As investors focused on both cost and disappointing performance in managed funds of all types a trickle of funds into passive vehicles in the early 90s grew to a tsunami. Today, a huge portion of net new cash flows goes to low cost passive funds. And it grows every day.
As assets poured into passive funds massive economies of scale developed for the sponsors. They cut expense ratios to further attract additional capital. Competition raised its beautiful head and a race for the bottom accompanied by huge advertising campaigns developed. Suddenly, players like Schwab, Fidelity, State Street, Blackrock and Vanguard race to have the cheapest funds.
As an example expense ratios in State Street’s Broad Market Index (SPTM) ETFs have fallen to just 3 basis points. That’s 0.03 percent which is $30 per $100,000 per year. And Developed ex-US are 4 basis points. So, using just two ETFs you could establish core positions in almost the entire world markets for 3.5 basis points. Vanguard’s ETFs are only one basis point higher.
The cost advantage to investors is huge. Throughout many asset classes the average cost savings may be 1.25% or more when compared to the category average actively managed fund.
Over time lower costs result in dramatically higher accumulations. Buying funds isn’t like buying many consumer goods where you expect to get what you pay for. You pay more for a Mercedes than a Ford Fiesta, but you also get a better quality. On the other hand, with high cost actively managed funds, you get lower returns, higher risk, and more tax exposure.
ETFs work best in large liquid markets where they make excellent core positions. In thinly traded illiquid markets, or in small market segments, or in very small issues, traditional mutual funds may better. Because ETFs trade on the open market small issue ETFs bid-ask spreads may become very high. The costs to trade the underlying assets are high. And some small ETFs liquidate if they don’t raise enough capital. This could have bad consequences at tax time for the affected shareholders.
As an example, suppose some bright guy decided the world needed an ETF covering Chilean Copper Mines. That might be a good one to avoid. There are not many issues, they don’t trade frequently, there might be little or no liquidity, the bid-ask spread on the issue would be enormous, and if not enough other investors thought a Chilean Copper Mine ETF was an inspired idea, the fund might liquidate.
Because there may not be enough investor interest, or the structure is inappropriate some very attractive asset classes with high expected returns are bad candidates for ETFs. For instance, micro-cap stocks, foreign small cap value, or emerging market small company funds are most likely best accessed through traditional mutual funds.
There are many good reasons why you might like to have an emerging market small company allocation in your holdings. But, with less liquid underlying holdings you are probably better served in a classic mutual fund.
Unfortunately, many truly bad ideas have migrated into the ETF universe. Just because it’s an ETF doesn’t make it a great investment. Active management is always a poor choice. Likewise, avoid leveraged ETFs, inverse ETFs, and futures ETFs. Dumb ideas are always dumb ideas no matter what kind of wrapper they come in. So, investors must still pick and choose wisely.
Because of the intense competition from ETFs, Mutual Fund expenses are also falling. But, there are additional expenses to running a mutual fund due to shareholder services. It’s unlikely they will ever fall as low as ETFs that don’t bear those administrative burdens. Having said that, there is always a place for well-designed mutual funds in your portfolio.
The falling expenses ratios for both Mutual Funds and ETFs have benefited US investors more than other countries. The rest of the world lags behind by about 15 years. But, they will surely follow the same trajectory. We are starting to see lower cost ETFs and funds in the developed economies and specially designed “offshore” funds and UCITS.
The trend is irreversible and inevitable. Adoption of low cost passive vehicles has and will continue to accelerate, and pricing will fall dramatically. Catch the wave and benefit.