Opinion

John Wasik

In ETF war, investors finally win

November 1, 2010

A trader cheers as the Dow Jones industrial average approaches the 10,000 level on the floor of the New York Stock Exchange, October 14, 2009. Reuters/Brendan McDermidImagine a financial services war in which prices dropped and benefited both investors and providers.

Such a conflict is waging in the exchange-traded fund (ETF) arena, where commission and fund management fees (“expense ratios”) are both coming down. This is exciting for cost-conscious investors because it can boost your total return with only a handful of funds.

Because you are paying less upfront (no sales charges) and annually (management expense ratios), your net return can be higher.

Leading discount brokers such as Schwab and TD Ameritrade have slashed their commissions on some popular ETFs to zero. Fund managers like Fidelity and Vanguard have also zeroed out commissions for select ETFs through their brokerage platforms.

ETFs are useful tools that most mainstream investors probably don’t know about or understand. They are pools of securities like mutual funds, only they trade on exchanges. Repriced constantly when the market is open, you can only buy them through brokers. Most ETFs are passive index portfolios, so they can keep costs low — much lower than actively managed mutual funds.

Not only are you getting to buy an elite group of ETFs without paying a brokerage fee — only if you buy through the above-mentioned brokers — you’re getting passive broad-basket ETFs at rock-bottom management expenses.

Let’s say you want to buy a global stock fund to get a sampling of stocks across the world. If you went through a full-service broker like UBS, the Swiss bank and brokerage, they might pitch you their Global Allocation A fund (BNGLX). For the privilege of investing in this fund, they’d charge you a stiff 5.5% upfront sales charge plus 1.22% annually in management expenses.

Suppose you wanted to buy a global stock index fund on your own. You could buy the iShares MSCI (ACWI) Index ETF through Fidelity‘s online brokerage commission free and pay 0.35% annually. So not only do you get a worldwide stock portfolio, you’re saving three and half times the annual expenses over the UBS fund and the commission.

Picking the right no-commission ETF can get confusing, though. Do you just pick the cheapest funds? The ones with the greatest diversification? Yes and Yes.

It’s fairly simple to construct a core portfolio that will give you most of the world’s stock and bond markets. This is the kind of portfolio you buy and hold. To determine how much you should hold in stocks, it should roughly match your age. The older you get, the less stocks you should own. Disclosure: I own ETFs and mutual funds from Vanguard, iShares and Fidelity in my 401(k)s.

You want your core portfolio to protect against inflation, provide some growth and income. Here’s a low-cost, boiled-down portfolio that gives you a piece of most assets:

The Cheapo Core Portfolio


Fund: Schwab US TIPS Type:  (inflation-protect. bonds)     Ticker:   SCHP Expense:    0.14%
Fund: Vanguard Total Bond ETF Type: (US bonds)                 Ticker:    BND Expense:    0.12%
Fund: Vanguard REIT Type: (real estate trusts)                       Ticker:  VNQ Expense:   0.13%
Fund: iShares World     Type: (global stocks)                              Ticker:   ACWI Expense:   0.35%
Fund: PowerShares DB Com Index Type: (commodities)      Ticker:   DBC Expense:    0.85%

Bear in mind that not all ETFs are commission-free, nor are they worth considering.

The commission war has not touched the entire $1 trillion universe of ETFs — and that’s a good thing. If you want to actively trade ETFs, you should pay more, if for no other reason than to discourage you from market timing and attempting to pick hot sectors at the wrong time.

Fortunately, unlike the real-world shooting wars, the ETF battle will be a win-win situation for those who need to save more for retirement and other goals.

Comments
5 comments so far | RSS Comments RSS

John,

I would call this simple economics, as price and costs of operations come down, the cause stimulates an effect on demand, suppliers are now competition, like the credit card free of annual fee model, all suppliers are under pressure to follow suit, now all citizens feel free to go for credit cards, demand gets stimulated, the same principle is applied by Fed on interest rates.

Arvind Pereira
http://www.ArvindLeoPereira.co.nr

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