Why pay somebody, for something you can do yourself? I was raised by this ‘slogan’. Why pay somebody to fill you gas, when you can do it for free? (jk, I’m not that old). Why pay a maid to do your laundry when you can do it for free? (jk I’m not that rich). Why pay somebody to shovel my driveway when you can move further south? (I mean do it for free). I’ve always wondered the same thing about mutual funds, why am I paying somebody to simply buy one share of each company in the S&P500?
How have mutual funds performed?
So I would expect the average mutual fund to have outperformed 17.3%, or at least 16.3%. But in fact the performance of these funds was 13.9%. That’s 3.4% LOWER THAN S&P500, and 2.4% LOWER THAN WILSHIRE 5000. Many of these mutual funds simply tried to match the general stock market index. So why the lower return? An annual expense ratio of 1.5% definitely didn’t help.
What is an ETF?
An exchange traded fund is actually very simple. In theory, it is simply a mutual fund that can be purchases through an exchange like the New York Stock Exchange. By outsourcing many of the customer facing interactions to these exchanges, the ‘mutual fund’ can significantly lower their expenses.
In addition, a vast majority of ETFs are ‘passive funds’. This means they don’t hire a number of high wager stock pickers that try to outperform the underlying Index (such as S&P500). Instead they simply purchase the appropriate ratio of each stock in the Index. Since this type of task can almost be automated, these ETFs can lower their expense ratio even further.
So how big is the difference? Remember we previously mentioned that the average actively managed mutual fund expense ratio is 1.5% per year. A passively managed mutual fund, about 0.5%. A passive Index ETF, only 0.25%.
Vanguard Emerging Markets ETF (NYSE:VWO):
The Thousandaire Portfolio has been looking for some diversification and international exposure in Emerging Markets for a while. VWO represents a low expense investment into the broader Emerging Markets. More importantly it requires minimal research from our part.
Although most of this post has been about ETFs, I feel I should quickly mention a few things about Emerging Markets. If you are not an overthrown middle eastern dictator, and now live in a hole, I’m sure you’ve seen a nonstop barrage of news stories and expert opinions about how Emerging Markets are expected to outperform developed nations over the next few years. Taking a quick look at the economic growth of varying nations shows developed economies ~2-3%, emerging market economies ~7-10%.
This economic growth will have a significant impact on the stock market growth in these developing countries. Therefore, the Thousandaire portfolio will look for continued investments in companies in emerging markets, or companies in developed countries that will profit from increased consumption in emerging markets.
Alternatives:
There are a large number of ETFs out there today. Pick what area you would like to invest in, and I bet there is an ETF to match it. Fidelity (no association) even offers their top 25 ETFs with no trading fees.
Disclosure:
The Hoff doesn’t own any and doesn’t plan on purchasing within the next 60 days. Kevin owns VWO.
Kevin’s Take:
The Hoff was having some trouble coming up with a stock pick this week, and I recommended he add one of my stocks to the Thousandaire portfolio. I really like VWO because it is a great way for me to get involved with emerging markets without doing endless research. VWO lets me invest in emerging markets and provides immediate diversification. I’m a big fan, especially since it is down 2.6% YTD.
Important to note that ALL ideas, thoughts, and/or forecasts expressed or implied herein are for informational and entertainment purposes only and should NOT be construed as a recommendation to invest, trade, or speculate in the markets.
Great post! I’m honestly not confident enough to deal with all this myself. Luckily I have a fantastic financial adviser who is next to free. I can bank through Thrivent Financial for Lutherans and have had the best experience! My financial adviser even takes me to lunch to talk things out and make sure I’m on track. I will have to travel back here once a year or so after I’m done with school! I really hope he doesn’t up and retire soon! Then I’ll really be lost!
Can you tell your financial advisor I prefer Jimmy Johns for lunch?
On a more serious note, it is absolutely great that you have a financial advisor (that is next to free). Even then, I would always encourage everybody to get a little more hands on with their investments.
You don’t have to pick your own investments or stocks, but at the very least you should make sure you know what the advisor is selling you. During this recession too many people thought their advisor had placed them in a safe investment, and then watched 50% of their wealth disappear (or 100% in the case of Madoff)
I also own VWO. What matters most is low expenses (rather than if an investment is an ETF). Vanguard has many low fee open end mutual funds which I would also consider buying.
You said it best: “What matters most is low expenses”. The point of this post was not to tell everybody how great ETFs are, but instead to show everybody that you can get the same investment with lower expenses.
Vanguard has been a leader in low expense funds for a number of years (they invented ‘passive funds’) and even today they boast some of the lowest expense ratios in the industry. Even better once you hit a certain investment threshold you can qualify for ‘premier’ rates which are even lower.
VWO is a great ETF! I bought EEM though (for a different reason – I was trying to avoid trading cost and Fidelity was offering that as a part of their free ETFs).
But otherwise would’ve gone with VWO for their lower ER.
Both funds track the same index so they should perform in a very similar fashion.
It’s always a tradeoff between the upfront cost of trading fees or the ongoing cost of fund expenses. Which option is a better value for you depends on the amount invested and your investment horizon.
Why not change your own oil when you can do it for free? or fix your own plumbing when you can do it for free? or write your own Will when you can do it for free?
Because you can still screw up your car, house or your estate…Just because anyone can go and buy an ETF doesn’t mean everyone should.
Not everyone understands why you would want diversification into Emerging markets and those are the people that should look to a professional….
Most people don’t do those things, NOT because fixing your own pipes can mess up your house (the plumber can do that just the same). Most people don’t do those things because they don’t want to go to plumbing school and learn how to do it.
Investing is just the same. You need to do your own research and many/most of us should probably see a professional for a vast majority of our wealth. To polish up your statement a little bit: “Just because anyone can go buy a stock (or any security), doesn’t mean everyone should.”
However, every Monday I post on this blog not with hopes of providing complete financial advice (see a CFA for that), but for two reasons.
1.) Many people like to take a little bit of ‘play money’, and play around. This is a fun way to get started.
2.) Help everybody learn the basics. Many people blindly take the advice from their CFA. What if your mechanic said you needed 42 gallons of oil? What if your plumber said you needed platinum-plated pipes? If you CFA said you need a mutual fund with a 2.5% expense ratio, you should have the same reaction.
I think it’s more dangerous to put blind faith in someone just because he has letters like CPA after his name than it is to try to do it yourself.
If you are a high net worth individual, it’s probably smart to have an adviser and let them get you involved in very sophisticated investments, but I still think it’s important to understand at a high level what is happening with your money.
^^ I think you guys might mean CFP. I mean, the economy is pretty terrible, but I don’t think you’re going to find a CFA willing to talk to you unless your wealth is already in the millions. Besides, most don’t work client-side.
Definitely agree on the don’t trust people just because of the letters. Honestly, when I see CFP after someone’s name I just see their license to steal money. Anyone wanting to help you fix your finances/make better investments that works on commission probably doesn’t always have your best interests in mind.
I agree Kevin! Thanks for submitting this post the this month’s Carnival of Passive Investing!
I think that passively managed ETFs are great – especially for people just beginning to invest! I actually own VWO myself! You don’t have to pay any commission when you trade it in a Vanguard account.
What’s your take on index mutual funds?
MoneyCone pointed out that there are mutual funds that track the same investment (he/she mentioned EEM which is also a Vanguard fund tracking the same index).
Here are the two differences I see between them:
1.) The fund value of a ETF will always outperform that of a mutual fund invested in the same index. This is because the mutual fund has to maintain a cash cushion in case people want to redeem their investments (this idle cash will not earn a return). Also, mutual funds have to pay for the services to process the dispersements resulting in higher expenses.
2.) ETF prices can swing up and down depending on the demand for a certain ETF (regardless of fund value). Although the ETF price pretty closely tracks the fund value, there are times that they differ a little.
Given a time horizon of 20+ years, I would always chose the ETF (as long as they have equivalent underlying investments) because the lower expenses can compound to a large difference.
>>he/she mentioned EEM which is also a Vanguard fund tracking the same index).
Hoff, EEM is owned by BlackRock/iShares, not Vanguard. But both VWO and EEM track the same index, MSCI EM. I suppose that’s what you meant! 🙂
But yes, your points are spot on!