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We often see mutual funds as the all-inclusive solution to our investment plan. Many times, we either ask our friends, colleagues, neighbors, or even our brokers to give us some ideas. Or, we pick the best performing mutual fund over the past 3 years, and then hope to earn the returns we want. Whichever method you choose, you may have made the wrong choice to begin with, leading you down a dangerous “set it and forget it” path.
The Drawbacks of the “Set It and Forget It” Plan
The first drawback is performance. When was the last time you compared your mutual fund’s performance (after fees, of course) with that of a stock market (like the S+P 500 index)? rarely? You might want to see if there is a significant difference when comparing your fund’s year-to-date performance versus a benchmark such as the S+P 500 Index. Even small differences of 2-3% in our annualized returns versus the market can make a big difference in whether you retire rich or not, or even at risk of retiring Can also pick up.
The second drawback is a management problem. Remember how we got into that “great” performing fund either by using a friend’s recommendation or by searching through short term exposure? The fund was run by a 20 year veteran who, unbeknownst to us, retired a year ago. The current fund manager is slightly wet behind the ears. Unfortunately, we did not bother to check whether the fund is still being managed by the same person who has earned handsome returns. Oops!
A third drawback occurs when new and more efficient ways of investing your money are introduced to the market, and we fail to take advantage of diversifying them from our portfolio. I am talking about Exchange Traded Funds (ETFs).
Exchange Traded Funds (ETFs)
An ETF is a basket of stocks that mirrors a particular index that holds exactly the same number of stocks as are in the index (see chart below). So if an index, such as the S+P 500, goes up, your ETF goes up by the same amount. And if the index goes down, your ETF will go down by the same amount. By trading a particular ETF, you are essentially trading that index. Another way to look at it is that ETFs provide us with an opportunity to trade an index at an individual investor level.
For example:
S+P 500 Index SPY (the S+P index we can invest in)
IBM = IBM
ge = ge
McDonald’s = McDonald’s
Why are ETFs better than most mutual funds?
– ETFs have significantly lower fees than mutual funds, with the most active ETFs charging .08% with most fees as low as .5%. (Foreign ETFs exceed .5%)
Investing in a broad-based ETF like SPY, which mirrors the S+P index, can give you “set it and forget it” flexibility
– No additional fees, no load fees, no junk fees for most ETFs
ETFs trade just like stocks. You can go long or short. And you don’t have to wait until the end of the day to cash out. Get in and out at any time.
– Because they trade like stocks, you can use a stop loss program to reduce your risk.
Like mutual funds, ETFs can quickly add diversification to your portfolio because they mimic an entire index of stocks without adding the risk of a single stock investment.
– There are no management changes to worry about
There are a wide variety of ETFs to choose from by searching sites like Yahoo Finance, ETF Connect, Morningstar or your broker’s site to find one that will meet your investment objectives.
Are ETFs Foolproof?
By now, you may think that ETFs are infallible. I am afraid not. For example, most ETFs trade fewer than 250,000 shares in a single day. Therefore, we must use limit orders to get in and out of our positions. We may experience higher slippage (poor fills on your orders) on low volume ETFs. But keep in mind, this may be insignificant as an ETF with lower volume may offer higher returns!
Finally, choosing a narrow industry ETF can be just as financially risky as if you had chosen a sector mutual fund in that industry. For example, choosing an oil ETF can be the same as choosing an oil fund or trading oil. This is why we need to look at the right diversification mix so that we can reap the benefits of solid returns while minimizing our risk.
Is it even worth my time to convert my portfolio?
I know what you’re thinking. “Thanks for the info, Lee. But why would I switch my mutual fund portfolio to an ETF? I’m very comfortable with what I have.” OK, are you ready for jaw-dropping statistics? According to several financial studies, the S+P 500 Index outperforms 80% of the returns of actively managed funds. This means that there is an 80% chance that your mutual fund will underperform the market, and this does not include fees. Ouch!
A study by the Investment Company Institute reported that investors paid 1.5% in expenses on stock mutual funds in 2005. Now if the S+P makes 8% for one year, you not only have an 80% chance of missing that number, but you’ll be paying at least 1.5% in expenses. So you have an 80% chance of making no more than 6.5%.
Highly respected investment guru John Bogle of Vanguard Investments recently conducted a detailed long-term study on average mutual fund performance after expenses and management fees. They found that over the 25-year period from 1980 to 2005, the S+P 500 index returned 12.3%, while the average mutual fund returned 7.3%. That’s a 5% difference.
-Past performance is not indicative of future performance
the proof is in the pudding
Let’s see what a 5% difference can do over 25 years. A $10,000 investment in the S+P 500 Index would earn $181,758 during that 25-year period, while the same $10,000 investment in the average mutual fund would only return $58,209 during the same time frame. That’s a difference of $123,549 that we are losing in fees and performance by investing in mutual funds. Are we starting to see the advantage of low expense ETFs versus professionally managed mutual funds?
What if we amplified that same performance and automatically added $200 per month to our account every month. The same $10,000 investment yielding 12.3% would return $558,118 over the same 25-year period.
This is why it becomes very important to not only ensure that your current returns at least match the markets, but also grow your capital on a monthly basis. If you can’t honestly say that your investments are matching or beating the markets, think about making some immediate changes.
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