Friday, March 28, 2014

Why you may want to avoid ETFs

By Mark Hulbert

Opinion: Open-ended index funds can offer a better deal

Here is a surprise for most investors: Exchange-traded funds aren’t always cheaper than traditional open-end mutual funds.

True, ETFs have much lower expense ratios than the typical open-end fund. The average ETF’s annual fee is currently 0.58%, versus 1.24% for the average open-end fund, according to data from investment-research firm Morningstar.

But the numbers can be misleading. For starters, they aren’t based on an apples-to-apples comparison, according to Joel Dickson, a senior investment strategist at Vanguard Group, which sells both ETFs and conventional funds. Most ETFs are low-cost index trackers, he said in an interview, while most open-end funds are actively managed, which have higher expense ratios — in part, at least, because they cost more to run.

On average, open-end index funds actually have half the expense ratio of index ETFs, Dickson says.

Moreover, expense ratios are but one of several factors that affect the true cost of fund ownership. Dave Nadig, chief investment officer at, a research firm, says that these other factors have just as large an impact on a fund’s cost as its expense ratio, if not more. A fund’s “headline expense ratio is very misleading,” he says.

These other costs fall into three categories.

Transaction costs

These apply primarily to ETFs, since — provided you focus on no-load funds — you can often buy open-end index funds without a commission. With an ETF, you can pay a commission both to your broker as well as in the spread between the ETF’s bid and offer price.

Without taking these commissions into account, many index ETFs will appear to be cheaper than open-end funds benchmarked to the same index. When transaction costs are included in the calculation, however, open-end funds become more competitive. For example, a $10 brokerage commission on a $10,000 purchase adds 0.1% to an ETF’s cost of ownership, possibly eliminating several years’ worth of the savings you otherwise would have realized by going with it rather than the open-end fund.

To be sure, if you are a short-term trader, ETFs may very well enjoy a transaction-cost advantage, since open-end funds often impose redemption fees when selling shares held for only a short period.

Tracking error

Tracking error refers to how much an index fund’s returns diverge from that of the market average to which it is benchmarked. It can lead to big differences in the ultimate costs of various funds.

Tracking error sometimes varies widely over time for the same fund. Consider the iShares MSCI Brazil Capped ETF /quotes/zigman/264176/delayed/quotes/nls/ewz EWZ +0.94%  , with a 0.61% expense ratio.

According to Nadig, there have been some 12-month periods in which the fund has beaten its benchmark by 1.25% and others in which it has lagged by 3.57%. With a swing in tracking error that big, he says, the fund’s expense ratio of 0.61% “becomes sort of irrelevant.”

By contrast, Nadig points to another emerging-markets index fund whose tracking error has fallen within a much more narrow range: the iShares Core MSCI Emerging Markets ETF /quotes/zigman/12337698/delayed/quotes/nls/iemg IEMG +1.22%  , with an expense ratio of 0.16%.

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