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MY FINANCIAL ADVISOR has been on a mission to reduce my investment costs. He’s been replacing my low-cost, broad-based index mutual funds with the exchange-traded fund (ETF) version. He believes this will improve my investment returns over the long run.
For instance, if you own Vanguard Total International Stock Index Fund—a mutual fund—you’re currently paying 0.11% in annual expenses. But Vanguard’s ETF alternative charges just 0.08%, equal to a savings of three cents a year for every $100 invested. That might seem small, but my advisor assures me it can translate into significant savings over time.
You purchase mutual funds directly from the fund company involved, with the price set as of the 4 p.m. ET market close, while ETFs can be traded whenever the stock market is open. I believe switching to ETFs is the right thing to do. But I had doubts about how large the savings would turn out to be. It’s hard to imagine saving three cents a year on every $100 can amount to a whole lot of money.
The upshot: Using NerdWallet’s mutual fund fees calculator, I decided to see how higher costs can impact a hypothetical $1 million retirement portfolio that enjoys 9% annual stock returns and 3% bond returns over a 25-year period.
I used Vanguard mutual fund and ETF expense ratios to determine the estimated 25-year cost, basing the calculation on a hypothetical portfolio with the following initial asset allocation: Vanguard Total Stock Market Index 35%, Total Bond Market Index 35%, Total International Stock Index 15% and Total International Bond Index 15%. Thereafter, no further money was added, and the portfolio wasn’t rebalanced.
Result? Check out the accompanying table. Keep in mind that the ETF cost excludes the modest sum you might lose to the bid-ask spread when you buy or sell an ETF. What can we learn from the table?
Dennis Friedman retired from Boeing Satellite Systems after a 30-year career in manufacturing. Born in Ohio, Dennis is a California transplant with a bachelor’s degree in history and an MBA. A self-described “humble investor,” he likes reading historical novels and about personal finance. His previous articles include 11 Remodeling Tips, Trust but Verify and No Vacation. Follow Dennis on Twitter @DMFrie.
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Jonathan Clements has identified three disadvantages of ETFs over mutual funds: getting a suboptimal price per share due to trade execution issues, bid-ask spread, premium/discount from the NAV. These disadvantages represent costs that one incurs when using an ETF share class instead of a mutual fund share class.
An investor incurs these costs when he or she makes the initial investment and also when he or she eventually sells the investment. Further, an investor incurs these costs on an ongoing basis as part of rebalancing transactions.
Given these myriad costs associated with ETFs, is it worthwhile to use an ETF share class instead of a traditional mutual fund share class despite the lower expense ratio for the ETF share class? We are frequently told that “there is no free lunch” in investing except for diversification and rebalancing. Is it possible that the lower expense ratio of ETFs is not a ‘free lunch’? Thanks for your response.
Doesn’t the advisor fee negate any fee savings using ETFs? In just seven years it appears. It’s like I have any idea to save you $20,000 over 25 years, but it will cost you $75,000 to learn what it is. What is the other advice value?
If Dennis stuck with the higher-cost index mutual funds, rather than swapping to the ETFs, he’d still be paying for the advisor, so the cost of the advisor is immaterial to the choice.