We often view mutual funds as a one-stop solution for our investment plan. Too often, we ask our friends, co-workers, neighbors, or even our brokers for some ideas. Or we just pick the best performing mutual fund over the last 3 years and then walk away expecting to achieve the returns we want. Whichever method you choose, you may have made the wrong decision at the start, 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 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)? Seldom? You may want to see if there is a significant difference by comparing your fund’s year-to-date performance to a benchmark like the S+P 500 Index. Even the seemingly small gaps of 2-3% in our year-to-date returns vs. to the market can end up making a big difference in whether or not you retire rich, or even if you can afford to retire.
A second drawback is a management problem. Remember how we got into that “fabulous” yield fund using a friend’s recommendation or looking through short-term yield? The fund was run by a 20-year veteran who, unknown to us, retired a year ago. The current fund manager is a bit wet behind the ears. Unfortunately, we didn’t bother to check to see if the fund was still being managed by the same person who made those fabulous returns. oops!
A third issue arises when new and more effective ways of investing your money are introduced to the market, and we fail to leverage them out of our portfolio. I’m talking about Exchange Traded Funds (ETFs).
Exchange Traded Funds (ETFs)
An ETF is a basket of stocks that reflects a particular index that contains exactly the same stocks that the index has (see 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. When trading a particular ETF, you are essentially trading that index. Another way of looking at it is that ETFs allow us the opportunity to trade an Index at the 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 compared to mutual funds, with most fees well below 0.5% and the most active ETF charging 0.08%. (Foreign ETFs tend to be above 0.5%)
– Investing in broad-based ETFs like the SPY, which mirrors the S+P Index, can give you the flexibility to “set it and forget it.”
– For most ETFs, there are no additional fees, no loading fees, and no junk fees
– ETFs trade like stocks. You can go long or short. And you don’t have to wait until the end of the day to check out. Come and go whenever you want.
– 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 by mimicking an entire stock index, without adding the risk of a single stock investment.
– No management changes to worry about.
– There are a wide variety of ETFs to choose from that will meet your investment goals, by searching sites like Yahoo Finance, ETF connect, Morningstar, or your broker’s site.
Are ETFs foolproof?
By now, you may think that ETFs are foolproof. I’m afraid not. For example, most ETFs trade less than 250,000 shares in a single day. As such, we should use limit orders to enter and exit our positions. It is also possible that we will experience more slippage (poor developments in your order) in the smaller volume ETFs. But keep in mind that this may be negligible as a smaller volume ETF may offer higher returns!
Finally, selecting an ETF from a limited industry can be just as risky financially as if you had chosen a sector mutual fund in that industry. For example, 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 that we can enjoy the benefits of strong performance, while minimizing our risk.
Is it worth changing my portfolio?
I know what you’re thinking. “Thanks for the info, Lee. But why the hell would I switch my portfolio from mutual funds to ETFs? I’m pretty comfortable with what I have.” Well, are you ready for an amazing stat? According to various financial studies, the S+P 500 index outperforms 80% of actively managed funds. That means your mutual fund has an 80% chance of underperforming the market, and that doesn’t include fees. Oh!
A study by the Investment Company Institute reported that investors paid 1.5% in stock mutual fund expenses in 2005. Now, if the S+P earns 8% over a year, you don’t just have 80% chance of underperforming that number, but have to pay at least 1.5% in expenses. So you have an 80% chance of getting no more than 6.5% at best.
Respected investment guru John Boggle of Vanguard Investments recently conducted a detailed long-term study of the average mutual fund’s performance after expenses and administration fees. He found, over a 25-year period from 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 difference of 5% can make in 25 years. A $10,000 investment in the S+P 500 Index would generate $181,758 over that 25-year period, while the same $10,000 investment in the average mutual fund would generate just $58,209 over the same time period. That’s a difference of $123,549 that we’re losing in fees and performance by investing in a mutual fund. Are we beginning to see the benefit of a low-cost ETF versus a professionally managed mutual fund?
What if we beat that same performance and only add $200 per month automatically to our account every month? A $10,000 investment yielding the same 12.3% return would generate $558,118 over that same 25-year period.
That is why it becomes very important to not only make sure that your current performance at least matches the markets, but also to increase your capital on a monthly basis. If you can’t honestly say that your investments have matched or outperformed the markets, consider making some immediate changes.