ETFs: Your Future Self Will Thank You

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In 2012 investors put a total of $154 billion into exchange traded funds, or ETFs, while removing $119 billion from mutual funds. The move from actively managed mutual funds to passive ETFs is a good one for investors. ETFs tend to have far lower fees than mutual funds, which in the long term matters quite a bit. A lot of money is being moved into bond ETFs, which is another problem entirely, but investors moving money from mutual funds to stock-based ETFs are most likely making the right move.

The Pros Aren't Very Good

On average, mutual funds tend to underperform major indices. Of course, some active fund managers do very well in the long run, averaging returns well above the market as a whole. The problem is finding that fund out of the sea of mediocre mutual funds. Unfortunately, many people choose the funds that have done the best recently, which is almost always a recipe for disaster. And because mutual funds charge much higher fees than ETFs (on average about 1.4% of assets), the funds need to do better than the ETFs just to match their performance after fees. If an ETF with an expense ratio of 0.1% returns 8% per year before fees than a mutual fund with an expense ratio of 1.4% must return 9.3% before fees just to match the ETF's performance.

The Race To The Bottom

Companies offering ETFs have been aggressively lowering fees in order to gain business. The three big ETFs which track the S&P 500 have rock-bottom expense ratios. The SPDR S&P 500 ETF (NYSEMKT: SPY) has an expense ratio of 0.09%., the iShares S&P 500 Index Fund (NYSEMKT: IVV) has an expense ratio of 0.07%, and the Vanguard S&P 500 ETF (NYSEMKT: VOO) has an expense ratio of just 0.05%. Specialized ETFs can have much higher fees, but generally the broad-based index tracking funds have extremely low fees.

The SPDR fund is the largest of the three ETFs, with a net asset value of $126 billion. This fund has been around since 1993 and is by far the largest ETF of any kind in existence. It also has the highest fee of the three. The iShares fund is the next largest with a net asset value of about $37 billion. This fund was formed in 2000 and is the sixth-largest ETF. The Vanguard fund is tiny in comparison, with a net asset value of just $7 billion. Founded very recently in 2010, this fund offers the lowest rate of the three and has the well-respected Vanguard name behind it.

An Experiment

In order to show just how detrimental the higher fees of mutual funds can be, let's imagine two hypothetical young investors: Billy and Johnny. Both are 25 and decide to start a retirement account for when they retire at age 65, 40 years from now. They initially invest $10,000 and plan to add an additional $5,000 each year. For simplicity I'll ignore taxes and trading fees. Billy decides to invest in an S&P 500 index fund, choosing the Vanguard ETF with a 0.05% expense ratio. Johnny decides to invest in a hot mutual fund which did really well last year. The expense ratio is 1.4%.

Over the 40 years of their investing lifetime both the ETF which Billy chose and the mutual fund which Johnny chose returned 8% before fees. Obviously, if this is the case, Billy will have a larger retirement account than Johnny. But how much larger?

<img src="/media/images/user_13886/retirement_1_large.png" />

At the end of 40 years Billy has $1,489,952 while Johnny has only $999,083. Billy has a full 49% more than Johnny! And as time goes on this difference gets even bigger. After 50 years it grows to 68% and after 60 years the difference is an astounding 91%.

The Bottom Line

High fees will kill your long-term returns. While some mutual funds outperform the market considerably, most will leave you disappointed. A much better alternative is to invest in a broad-based ETF such as the three mentioned above and enjoy near-inconsequential fees. Over the long run the high fees of mutual funds will eat you alive. Those running the fund get paid regardless of how they do, even if they lose your money. So do yourself a favor and stop paying exorbitant fees: your future self will thank you.

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