The Hot New Mutual Fund Tool

EXPENSES

When it comes to managing money, you are always going to encounter costs. These can include management fees, advertising and marketing costs, and administrative costs. These costs should not be ignored; even a slight difference can affect the performance of your investment.

Expenses are usually expressed in terms of basis points on an annual basis. For example, if the expense ratio of a fund is 18 basis points, you will end up paying 18% annually. These expense ratios do not include brokerage fees, which usually do not apply to mutual funds. However, when you buy or sell ETFs, you must pay commissions to your broker in addition to annual expenses.

There are several classes of exchange shares, such as Spdrs (Standard & Poor's depositary receipts), WEBS (World Equity Benchmark Shares), DIA (Dow Jones Industrial Average), HOLDRS (holding company depositary receipts), and sector SPDRS. These classes are set up differently, but all involve expenses. The expenses are similar to those of index mutual funds, such as advertising and marketing fees, plus fees to the Securities and Exchange Commission (SEC). These expenses are a percentage of the funds' assets. As the funds grow, typically, the expense ratios decline.

FIGURE 1: EXPENSE RATIOS. The expense ratios associated with some ETFs are displayed here. Expense ratios range from 0.09% to 0.97%.

The expense ratios of the largest exchange traded funds are displayed in Figure 1; note that the HOLDRs don't have any expenses associated with them. This is because they are unmanaged funds; hence, they don't have any management or maintenance fees, or sales loads. Instead, holders of these funds have to pay a quarterly custody charge of $2, which is waived if there are no dividends or distributions paid on any of the underlying stocks.

Generally, index funds are cheaper to manage than actively managed funds. The Vanguard 500 has the lowest expense ratio of all index funds, which at present is 18 basis points. Most index funds charge about 30 basis points. Since most ETFs are index funds, their costs will be less than those of actively managed funds.

The biggest cost advantage of ETFs over the traditional index fund is in back-end expenses. In a traditional open-end fund, a transfer agent like a bank takes on responsibilities such as maintaining accounts, keeping track of sales charges, and linking salespeople to customers. In an ETF, many of these transfer agent functions are eliminated, making the funds cheaper to manage. In addition, your broker handles all your trading activity, which involves keeping track of your buys and sells. Yes, this is a transfer agent function. However, in an ETF, it is simplified, making it more efficient and less expensive, and thus reducing the expense ratio.

BENEFITS

Can the reduced expenses associated with ETFs improve your investment returns? I compared the expenses of index funds and ETFs to determine whether there really is a cost benefit in owning ETFs. The expense ratios of ETFs ranged from 9 basis points, or 0.09% (iShares S&P 500), to 99 basis points, or 0.99% (iShares MSCI South Korea Index). Given this wide range, it is best to compare an ETF to funds of a similar class or category.

Fortunately, the Morningstar website (www.morningstar.com) has a section on ETFs that provides a cost analysis tool. This makes it easy to analyze costs between the traditional index fund and the ETF. The display in Figure 2 shows how this cost analysis tool works. Assuming an initial investment of $10,000, expected return of 10%, $15 commissions, and a five-year time horizon using the large blend as an example, the results display that after three years, the iShares 500 (IVV) was the least-expensive choice. After five years, the expenses associated with holding the Standard & Poor's 500 SPDR (SPY) were lower than those of the Vanguard 500 index fund (VFINX).

FIGURE 2: BUY AND HOLD. After five years, the iShares S&P 500 (IVV) was the clear winner.

If I invested $200 every month instead of making a lump-sum payment, what would be the difference in results? Using a similar time frame, commission, and rate of return, the results in Figure 3 show the Vanguard 500 index fund as the clear winner. There is a significant difference in total costs, which is no surprise, considering that for each purchase of an ETF you would pay a commission, which can eat significantly into your returns.

FIGURE 3: DOLLAR COST AVERAGING. If you are going to use dollar cost averaging, the traditional index fund, in this case the Vanguard 500 index fund (VFINX), is the least-expensive alternative.

The results of these analyses in no way suggest that these results are typical. I compared funds that had the lowest expense ratios; some ETFs, especially those with a focus on international markets, have higher expense ratios. In Figure 4, you can see an analysis of the European sector using a $10,000 initial investment, 10% expected return, a five-year time horizon, and $15 commissions. Due to higher expenses involved with the ETFs, the Vanguard European Stock Index fund was the least expensive choice.

FIGURE 4: EUROPEAN FUNDS. Here, the Vanguard European Stock Index (VEURX) is the clear winner after five years.

SUMMARY

Before plunging into ETFs, do a cost analysis and determine whether ETFs are likely to help you reach your investment goals. Clearly, if you follow the buy-and-hold strategy and make a lump-sum initial payment, you may find ETFs to be cost effective. However, if you plan to use dollar cost averaging, you are better off using conventional mutual funds.