We often see mutual funds as an all encompassing solution to our investment plan. Too often, we either ask our friends, co-workers, neighbors, or even our brokers to give us some ideas. Or, we just pick the best performing mutual fund in the last 3 years, and then walk away expecting to achieve the returns we want. Whichever method you chose, you may have made the wrong choice to begin with, leading you down the dreaded “set it and forget it” path.
The drawbacks of a “set it and forget it” plan
The first drawback is performance. When was the last time that you compared your mutual fund’s performance (after fees, of course) to the performance of the stock market (such as the S+P 500 index)? Rarely? You may 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 seemingly small gaps of 2-3% in our yearly returns versus the market can end up making a large difference in whether you retire wealthy or not, or can even afford to retire at all.
A second drawback is a management issue. Remember how we got into that “fabulous” performing fund using either a friend’s recommendation or by searching via short term performance? The fund was run by a 20 year veteran who, unbeknownst to us, retired a year ago. The current fund manager is a little wet behind the ears. Unfortunately, we didn’t bother to check whether the fund was still being managed by the same person who earned those fabulous returns. Oops!
A third drawback comes when new and more effective ways to invest your money are introduced to the market, and we fail to take advantage of making them apart of our portfolio. I am talking about Exchange Traded Funds (ETFs).
Exchange Traded Funds (ETFs)
An ETF is a basket of stocks that mirror a particular index that holds the exact same stocks as the index has (see the chart below). So if an index, like 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 allow us to have the opportunity to trade an Index on an individual investor level.
S+P 500 Index SPY (the S+P Index that we can invest in)
IBM = IBM
GE = GE
McDonalds = McDonalds
Why are ETFs better than most mutual funds?
– ETFs have significantly lower fees as compared to mutual funds, with most fees well below .5% with the most active ETF charging .08%. (Foreign ETFs tend to be higher than .5%)
– Investing in broad based ETFs like the SPY, which mirrors the S+P index, can get you the “set it and forget it” flexibility
– For most ETFs, there are no additional fees, no load fees, no junk fees
– ETFs trade just like stocks. You can go long or short. And you don’t have to wait for the end of the day to get out. Get in and out anytime.
– Because they trade like stocks, you can use a stop loss program to reduce your risk.
– Like mutual funds, ETFs can quickly add diversity to your portfolio since they mimic an entire index of stocks, without adding the risk of single stock investment
– There are no management changes to worry about
– There are a wide variety of ETFs to choose from that will satisfy your investment objectives, by searching sites like Yahoo Finance, ETF connect, Morningstar or your broker’s site.
Are ETFs foolproof?
By now, you may think ETFs are infallible. I am afraid not. For example, most ETFs trade fewer than 250,000 shares in a single day. As such, we should use limit orders to get in and out of our positions. We may also experience more slippage (poor fills on your order) on the lower volume ETFs. But keep in mind, this may be insignificant as a lower volume ETF may offer higher returns!
Finally, selecting a narrow industry ETF can be just as financially risky as if you had chosen a sector mutual fund in that industry. For instance, choosing the Oil ETF can be the same as choosing an Oil fund or trading Oil itself. This is why we need to pay attention to the right diversification mix so we can enjoy the benefits of a solid return, while minimizing our risk.
Is Changing My Portfolio Even Worth My Time?
I know what you’re thinking. “Thanks for the info, Lee. But why the heck would I change my mutual fund portfolio to ETFs? I am pretty comfortable with what I have.” Well, are you ready for a jaw dropping statistic? According to several financial studies, the S+P 500 index beats the returns of 80% of actively managed funds. That means your mutual fund has an 80% chance of underperforming the market, and it doesn’t include fees. Ouch!
One 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 underperforming that number, but you have to pay at least 1.5% in expenses. So you have an 80% chance of making not more than 6.5% at best.
The highly regarded investment guru John Boggle of Vanguard Investments recently performed a detailed long term study on the performance of the average mutual fund after expenses and management fees. He found, over a 25 year period of 1980 to 2005, that 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 make over 25 years. A $10,000 investment in the S+P 500 index would yield $181,758 during that 25 year period, while the same $10,000 investment in the average mutual fund would return a mere $58,209 during the same time frame. That’s a $123,549 difference we are losing in fees and performance by investing in a mutual fund. Are we beginning to see the benefit of a low expense ETF versus a professionally managed mutual fund?
What if we supersized that same performance and just add $200 a month automatically to our account every month. A $10,000 investment yielding the same 12.3% return would return $558,118 during that same 25 year period.
This is why it becomes very important not only to make sure your current return at least matches the markets, but to also add to your capital on a monthly basis. If you can’t honestly say that your investments have matched or beaten the markets, think about making some immediate changes.