ETF Investing has replaced mutual funds but the biggest reason to invest in funds remains the same
Too many people still think investing in mutual funds is the best option to meet their retirement goals. ETF investing has replaced mutual funds in nearly every way including lower costs and taxes.
In fact, investing in ETFs versus mutual funds could save you $162,357 over the course of 30-years.
That buys a lot of sunscreen to use on your island paradise!
We’re up to the 9th post in our review of The Intelligent Investor, one of the most popular investing books ever written. The book is the ultimate read for value investing and understanding how individual investors can meet their investing goals.
Pick up your copy of The Intelligent Investor and follow along with the series. I’m using the 2003 edition with commentary by Jason Zweig, writer of the Wall Street Journal’s Intelligent Investor column.
Start on our first chapter review to learn how the intelligent investor can avoid hot stocks that could be ready to plunge.
Graham doesn’t mention exchange traded funds (ETFs) in the book, the stock-like investment funds weren’t available until years after he died in 1976. ETFs really hadn’t gained that much popularity by the time the 2003 version of the book came out with just 102 funds trading in 2002.
There were nearly 4,400 ETFs available last year holding more than $2.2 trillion in investments. They’ve gone mainstream so I thought I would fill in where the book leaves off.
What are Exchange Traded Funds (ETFs)?
To look at them, there seems almost no difference between mutual funds and ETFs. Both are an investment in a group of stocks by an investment manager. The specific stocks are picked on some strategy or based on an index.
There are funds that hold as little as a few dozen stocks and some that hold thousands of stocks. There are funds that change their investments frequently and others that hold a stock for years or even decades.
The differences between ETF investing and mutual funds are pretty striking:
- ETFs trade just like stocks while your broker can only buy a mutual fund at the end of the day. You can get the same immediate transaction guarantee for ETFs that you get for stocks on my online investing sites. You’ll never know how much you pay shares of a mutual fund until the end of the day.
- Costs are higher for mutual funds. Morningstar reports the average U.S. Mutual Fund charges a 0.9% annual fee versus just 0.53% annually on the average ETF.
- Mutual Fund investors lose to the tax man. The way mutual fund investments are sold by the manager means investors could have a tax bill even if they didn’t sell any of their shares. Lipper Research reported that the average mutual fund lost 0.8% annually over the decade through 2012 because of this tax drag. Bond mutual funds got hit even harder with a 1.8% annual loss on taxes.
- Yet More Costs! Mutual funds have bloated management and reporting structures that pile the fees up. A study by Edelen, Evans and Kadlec finds that costs from brokerage, commissions and spread cost mutual fund investors another 1.44% each year. That still doesn’t include separate fees you pay to an advisor which can be as high as 5% off the top of your initial investment.
Still not convinced why you should invest in ETFs instead of mutual funds? The graphic below shows the cost of investing fees over a 30-year period. If you invested $5,000 a year into the average ETF and earned a 6.5% annual return, you would have just over $419,000 to retire on. Kinda sucks that you would have lost $45,913 in fees but that’s still a pretty choice sum on which to retire.
Consider yourself lucky though because the mutual fund investor would have lost $208,270 to fees, paying over 3.1% a year to fund managers. Because the mutual fund investor spent their whole life making the fund managers rich, he only has about $256,000 on which to retire.
Investing in ETFs instead of mutual funds could save $162,357 over three decades!
ETF Investing is about More than Just the Cost
This is where we get back to Graham’s reasons to invest in mutual funds. Both ETFs and mutual funds may actually underperform the group of stocks held each year. Even the relatively low costs on ETFs can weigh on returns but there are still two very important reasons why you want to invest in ETFs.
- Instant diversification and lower trading fees than trying to buy that many stocks. Even on the cheapest discount online site, buying the 500 stocks in the S&P 500 will cost you thousands of dollars. You can buy an ETF and get all 500 stocks with just one commission.
- Buying ETFs means you’re less likely to make the bad investor behaviors that lose money. Some stocks will rise while others fall on any given day but the overall change in the fund will be much smoother. You also won’t fixate on changes in specific stocks, panic selling on headline news.
You get just as much diversification and investment choices with ETF investing as you do with mutual funds. A few examples:
- SPDR S&P 500 (SPY) – holds all the stocks in the S&P 500 index, the largest companies in America. This is basically the U.S. stock market though it excludes smaller companies.
- VanEck Vectors Gold Miners (GDX) – invests in stocks of gold miners internationally.
- Financial Select Sector SPDR (XLF) – invests in the largest U.S. financial companies including banks, insurance and investment firms.
- iShares Russell 2000 (IWM) – invests in 2,000 small companies based in the United States.
- iShares MSCI Emerging Markets (EEM) – invests in companies based in emerging markets like China, India, Brazil and Russia.
It’s not an endorsement of these funds, just an example of the diversity you can find in ETF investing. You can invest in whole markets, industries, sectors, small or large companies and in different geographies.
ETF Investing Rules
Investing in ETFs is easy but a few rules will help you get the most out of the investment.
- Don’t invest in a specific ETF just because it has beaten other funds in the previous years. Most ETFs invest along a fairly strict set of guidelines so managers may have less to do with returns than in mutual funds.
- Understand that ETFs will track their specific group of investments but may differ from the general market. A gold miner ETF may not beat the stocks in the S&P 500 but should track its target group of stocks.
- You need to watch those fees even in ETF investing. Check back on the chart above. Vanguard charges an average of just 0.12% across its funds, even lower than the average ETF expense. Investing in low-cost ETFs means you pay just $10,871 in fees and get to spend your $454,075 nest egg livin’ it up in Boca!
- Make sure you diversify your investments. Investing in an ETF holding thousands of stocks doesn’t necessarily mean you’re diversified. You need to hold funds that invest along different themes including sectors, market cap, domestic and international.
If just putting your money in an ETF every month seems a little boring…well, yeah it is a little. It’s a smart way to invest but definitely a ‘defensive investor’ strategy to use Graham’s term.
My favorite investing strategy combines the safety and lower costs in ETF investing with the potential for a little higher returns to investing in individual stocks. We took a more detailed look at the core-satellite investing strategy in an earlier post. The idea is to invest the majority of your money in diversified ETFs to reduce risk and enjoy market returns. The remaining portion, up to a third of your portfolio, is invested in individual stocks you believe to have the most upside potential.
I use the core-satellite strategy on all the funds in which I invest on Motif Investing. Each fund holds a handful of ETFs that follow an investing theme and then nine to 13 individual stocks within the theme.
The best part about using Motif Investing is that I can buy the whole group of funds and stocks for one commission. I only pay fund fees on the money invested in ETFs and the site doesn’t charge any additional fees.
Chapter nine in The Intelligent Investor looks at good and the bad of investment advisors. It’s a subject getting even more attention lately with new rules around how advisors help you pick your investments. Be sure to grab a copy of the book and follow along with our review.
Investing in ETFs is as easy as investing in individual stocks and carries the benefit of lower costs and instant diversification. Perfect for the defensive investor, ETF investing should be a part of everyone’s investing strategy.