How Much Can An ETF Save You?

Sometimes investors ignore or don’t notice the impact of broker commissions and high fees on their investments. Now, there is an easy to use tool available at the Financial Industry Regulatory Authority, or FINRA website. FINRA is essentially the regulator of securities brokers and other investment firms and the website makes it easy to see what these costs can do to your long-term returns – and how much an ETF might save you. The tool is pretty intuitive and can be found here.

I recently ran an analysis showing the difference in returns between the American Funds Growth Fund of America A shares (the biggest equity mutual fund of them all) and the ishares S&P Growth ETF – an ETF highly correlated to the Growth Fund of America.  I assumed I was rolling over a $90,000 401k, that each fund would grow 8%, and that I would retire in 20 years.

The results surprised even me.  At the end of 20 years, the profit on the Growth Fund of America investment was $263,894, compared to the profit on the ishares S&P Growth ETF of $322,004 – a difference of $58,110.  The commissions and higher expenses of the American Funds mutual fund had reduced the returns by over 19% – astonishing.

One more thing to keep in mind.  The results don’t reflect the impact of taxes on your returns.  If my investment wasn’t in a tax-deferred account, the differences in returns would have been much, much bigger.

Jane Bryant Quinn: ETFs “Going In For the Kill”

Since actively managed mutual funds keep cash on hand to be able to meet daily customer redemptions, conventional wisdom holds that mutual funds should outperform index funds and ETFs in down markets because the cash acts as a cushion when there is a falling market.

That didn’t happen last year.  As Jane Bryant Quinn of Bloomberg explains – in fact, 58% of all actively managed funds lost more in value than the benchmark against which they measure themselves.  (Remember that the fund companies themselves get to choose the benchmark they want to be measured by).  Small-cap managers did much worse – 72% of them missed their self selected benchmark.

According to Quinn, the benefits of ETFs – lower costs, lower taxes – combined with their outperformance in a down market, have them “going in for the kill” against actively managed mutual funds.

Understanding Indexes

Nearly all ETFs track an index (the exceptions are a small number of actively managed ETFs). Where they differ, however, is what indexes they track and how they go about their tracking.  Understanding these differences is important to make sure you choose the right ETFs for your portfolio.  This is especially true as the number of ETFs proliferate.

Before investing in an ETF, there are a number of characteristics about its underlying index you should investigate and understand.  I’ve summarized the main ones below.

How are the components of the index selected?

Most indexes can be categorized as market indexes or custom indexes.
Market indexes are the most widely known kind and some of the largest ETFs track those indexes. A market index attempts to track the performance of a broad group of securities or sectors.  These indexes include the S&P 500 , Dow Industrials, and Nasdaq Composite index.  SPY is the largest ETF which tracks the S&P 500.
A custom index is simply any index constructed using specific rules to create a group of securities that doesn’t follow more widely known passive indexes. Many of them screen out certain companies based on qualitative or quantitative features using proprietary methodologies.  ETFs that track socially responsible or clean energy, for example, are based on indexes developed by companies using their own qualitative criteria of what those themes represent.  Similarly, quantitative indexes are ones using proprietary formulas to identify attractive companies in certain sectors of the market.  Powershares is by far the biggest player in ETFs that track quantitatively determined indexes.

How are components of the index weighted?

Are they market-cap weighted, equal weighted, or fundamentally weighted?  Once the components of an index are determined, the relative proportion of each component of an index must be determined.  Most of the large, passive indexes (think S&P, Wilshire, Russell and MSCI indexes) are market-cap weighted, which means the relative weight of a company in the index is based on the total value of its shares.  iShares, StateStreet, and Vanguard ETFs tend to be market-cap weighted indexes.  Some indexes are equal-weighted, meaning the size of each company doesn’t matter – each company has the same relative weight.  Rydex is probably best known as a sponsor of ETFs using equal weighting methodologies.  Finally, some indexes base the relative weights of a company in an index on fundamental factors, such as relative earnings or dividends.  WisdomTree is best known for its fundamentally calculated indexes.

How often is the index rebalanced and reconstituted?

When an index is rebalanced, the holdings of the index are bought or sold until they reach their intended weightings.  The more often an index is rebalanced, the chance of receiving a capital gain distribution is increased.  Also, the fund costs are likely to be higher.  The most widely followed indexes are generally rebalanced either annually or semiannually.  Many of the quantitative ones, however, are rebalanced quarterly and a few even are rebalanced monthly. When an index is reconstituted, the holdings of the index are actually changed.  For example, when a company is added to the S&P 500 index, an ETF tracking that index must purchase the new company and sell the company being removed from the index.  Similar to rebalancing, an index that is frequently reconstituted might increase the chance of capital gains in the ETF.

Once again, this isn’t an exhaustive list of items to consider.  There are other questions to ask (e.g., is the index intended to outperform a benchmark or match it? what company developed the index?), but understanding these three main aspects of ETF indexes should give you a framework for determining whether an ETF belongs in your portfolio.