More on ETF Fees

I’ve been meaning to do a follow up on the costs of ETFs vs. open-end index mutual funds. My post from February 5 on why ETFs should probably not be the mainstay of your investment diet has inspired interest (much to my surprise it continues to be one the most popular posts here) and a little bit of controversy.

To summarize what I said three weeks ago, the pecking order of low cost for investors is: open-end index mutual funds (best), ETFs, and then open-end active mutual funds (worst.) You will often see ETFs touted as being low cost, and relative to active funds this is certainly true, but the typical investor will do even better in an old-style index mutual fund.

For a change of pace, I thought I would gather some actual data to make my point. Yahoo Finance has a useful list of the largest ETFs. Let’s look at the five biggest, which together account for about a third of all the money in ETFs.

One of the five, at number 3, is a special case, the streetTracks Gold Trust, which strictly speaking is not really an ETF at all. It represents simply the ownership of gold bullion, and Yahoo informs us that it is not registered as an investment company under the 1940 act, which means that it is not a mutual fund. Apparently as a side effect of this, Yahoo does not list an expense ratio for it, so it’s not clear what the fees are. I am going to set this one aside, but I cannot resist remarking what a sign of the times it is that gold is in the top 5.

Numbers 1 and 5 are virtually identical S&P 500 ETFs, the giant SPDR Trust (SPY) and the Pepsi to its Coke, the iShares S&P 500 Index (IVV). Yahoo tells us that the expense ratio, i.e. annual fee charged by the manager, for these two is 0.08% and 0.09% respectively. Fidelity has a pretty big S&P 500 fund, the Spartan 500 (FSMKX) which charges 0.10% and, for investments over $100,000, the Spartan Advantage 500 (FSMAX) which charges 0.07%. Even a precision freak like me will concede that all these tiny numbers are practically the same.

Number 2 is the iShares MSCI EAFE Index (EFA) which charges 0.34% in fees. You can get the same thing from the Vanguard Developed Market Index (VDMIX) which charges only 0.22%.

And at number 4 we have the iShares Emerging Markets Index (EEM) which charges an impressive-in-a-bad-way 0.72%. Vanguard will charge you 0.37% for it’s Emerging Stock Index Fund (VEIEX) or only 0.25% if you have more than $100,000 in the Admiral version (VEMAX). Note that both Vanguard funds have a 0.25% transaction fee to invest or sell.

So from this sample, based only on management fees, you might conclude that ETFs are mostly the same, or sometimes just a little worse than open-end index mutual funds. But with ETFs, you still have more costs to consider. ETFs trade like stocks, which means that you need to pay money to buy them and sell them. You will pay your broker a commission, you will pay the bid-ask spread, and you will pay both of these things twice, on your way in and your way out. These additional costs (shouldn’t be) huge, but they do count and are more than enough to tip the balance in favor of old-school index mutual funds.

As I wrote in the previous post, ETFs do have their role. There are things you can do with them because they are stocks that you cannot do with an open-end fund, such as buy on margin and sell short. And there are some peculiar things that actually are cheaper as, or even available only as, ETFs. Gold might be an example, if only I could work out what that ETF charges. The Nasdaq Composite ETF (QQQQ) is another because there are so few open-end funds that bother tracking it. You might also just enjoy trading your ETFs more than investing in open-end funds. But if you want to know which will, in the long run, make you more money, the answer is open-end mutual funds, not ETFs.

No Comments

  • By Andrew Stevens, February 24, 2009 @ 10:04 pm

    I don’t think you’ve been very fair in your comparisons. You’ve selected the ETFs by popularity, but you’re cherry-picking the funds you’re comparing them with. For example, VWO, Vanguard’s emerging market ETF has an expense ratio of 0.25%, which is better than the Vanguard fund you selected (unless you put in more than $100,000). VEA, their Europe Pacific ETF, has an expense ratio of 0.12%, better than the fund you mentioned (though perhaps not strictly comparable). VV, their large-cap U.S. fund, has an expense ratio of 0.07%. Etc.

    I actually have a lot of ETFs in my portfolio and I feel fairly meh about them compared to my open-end funds. It’s true, of course, that if you buy and sell a bunch, fees will eat up the money pretty quickly with ETFs so I stick to buy and hold with the ETFs.

    Anyway, I think the whole “live for a week eating only pickles” was a cheap shot. If you’re a buy and hold investor and you’re careful about the ETFs you select, I don’t see any reason why you can’t have your entire portfolio in ETFs. On the other hand, the Million Dollar Journey post you linked to was doing excessive cheerleading on behalf of ETFs so perhaps it deserved a bit of a kicking.

  • By Frank Curmudgeon, February 25, 2009 @ 6:52 am

    An excellent comment. Thanks.

    I tried not to cherry pick, looking at the largest ETFs and comparing to the most obvious open-end fund alternatives. To be honest, I didn’t look at Vanguard’s ETFs at all. My bad.

    I also probably should have mentioned that there is no big picture reason why ETFs need to charge more (or less) than open-end index funds and that in the future they very well could be the less expensive choice.

    And cheap shot? I prefer the term frugal shot.

    I’m sure that there are many who think that I overuse humor and mockery here. Some may even feel it makes it harder to take me seriously. So be it. My hope is that the personal finance world will become more of a marketplace of ideas with a lively dialog about what makes sense. Part of that, I think, is not taking any one speaker too seriously, myself included.

  • By Idiot Stock Investor, October 24, 2010 @ 5:43 am

    I quite enjoyed this article Frank. I believe I am similar minded. I think normal people should be able to have normal and lively discussion about what makes sense and why, that is my perspective on investing (an idiot’s perspective if you will).

    Investing shouldn’t be made overly complex and we should keep things simple and tell it like it is, unlike the finance section and so-called analyst opinion which are all 100% self-serving to their industry or their respective firms.

    Going back to the ETFs, my take is that there is a good reason to own some. For example, I’d like to invest in Gold, but I can’t afford the $1348-$1378 an ounce (depends what day we’re talking about as of late lol) but in Canada we have 3 different gold/silver funds that are attractively priced ($12-$17 per share) and my opinion is that they are better than the GLD on the NYSE.

    I must admit that I don’t like mutual funds much. I’ve read before that some mutual funds can be more advantageous than ETFs when it comes to fees.

    I always like the idea of building in my margins and I remember with my discount broker it’s $20 USD in and out.

    Another example is that I invested in China Unicom and Mobile and was doing well until Vodafone sold billions of dollar worth of shares in both companies.

    If I had picked the BMO China ETF, I would be making money still, rather than be in the red and I would have had a basket of the top Chinese companies. Arguably it should mean that if China’s economy fares well, then the ETF should make money.

    Those are my 2 cents, and I agree in the sense that if you don’t have a good reason such as the above to use an ETF, avoid them because even small percentages eat into your profits.

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