ETFs, Mutual Funds and Fee Questions

By Nancy Zambell, Contributing Editor

The cheapskate mutual fund investor looks carefully at fees to make sure they match the value received. Some investors, in search of the best possible bargain, look to exchange-traded funds (ETFs) because they have a reputation for being so cheap. ETFs are not always the cheaper course, though. It all depends on the structure of the funds being compared and the value of those fees.

ETFs are set up as baskets of stocks held in trust. The fund manager buys the securities, then lists certificates on the market equal to the underlying value. These certificates trade in real time; investors looking to cash out either sell their certificates at any hour of the day or ask the fund manager for their share of the shares. Individual investors rarely ask for the stock, but large institutions do. This keeps the value of the certificates in line with market value; otherwise, an institution could buy an ETF trading at a lower value than the underlying index, demand the shares from the basket of securities and then sell the securities on the open market to lock in an easy, risk-free profit.

A mutual fund, by contrast, prices its securities only once a day. Trades happen only at the end of the day, and they always involve cash. If there are more redemptions than new investments, the fund sells some of its securities, which might trigger a capital gain. ETFs, instead, usually settle redemptions with securities, with no tax effect. However, ETFs sometimes have to sell securities. Effective Oct. 5, 2007, Standard & Poor's deleted Archstone-Smith (NYSE: ASN), a real estate investment trust that is being acquired, from the S&P 500 Index and replaced it with Noble Energy (NYSE: NBL). That means that everyone running an S&P portfolio had to sell Archstone-Smith and buy Noble Energy. The capital gain was passed on to investors, who have the fun of settling up with the IRS.

Someone has to be there to handle the transaction, and that someone expects a paycheck. ETFs have lower management fees than index mutual funds, but those fees aren't zero. They are likely to go up as ETFs become more complicated and more like actively managed mutual funds. Standard & Poor's changes the composition of big-kahuna 500 Index a few times a year. Meanwhile, some ETFs are investing in analytical work to develop their own indices to follow such variable market characteristics as growth and valuation. Such offbeat indexes will have frequent changes requiring a lot of buying and selling. That leads to fees: probably lower than for an actively managed mutual fund, but higher than for an ETF or mutual fund based on a simple, pre-set index. For example, the PowerShares Dynamic Consumer Discretionary Sector Portfolio carries a net expense ratio of 0.71%, while the PowerShares International Listed Private Equity Portfolio has an expense ratio of 0.75%. By contrast, the expense ratio for SPDRs, an ETF that tracks the S&P 500, is a mere .08%, and the expense ratio for the Vanguard 500 Index mutual fund is 0.18%.

Before you can pay taxes or fees, you have to get your shares and that will cost you in an ETF. Those shares are purchased through a broker with a commission. At Charles Schwab, the commission for a household with less than $1 million on accounts making fewer than 120 trades per year is $12.95 to buy and another $12.95 to sell. Vanguard's index funds carry no load. On a $10,000 investment, the expense difference between the SPDRs and the Vanguard S&P 500 fund works out to $10 a year, less than the cost of the commission to buy the SPDR. The expense difference pays off for the ETF holder with a time horizon of more than two years.  
  
  Here's the bottom line: ETFs are not necessarily cheaper than the equivalent index mutual fund, but they may give you more flexibility if you like to trade. They may be a better deal for taxable investors with long time horizons and for investors who want to try to profit from short-term market fluctuations. A no-load index mutual fund is a better deal for an investor who wants to add to the account over time, because there won't be a sales charge for each new investment; the lack of a commission will probably offset the higher expense ratio. 
  
  As for the really active trader with a very short term time horizon? A better way to trade the index might be a futures contract like the Chicago Mercantile Exchange's E-mini S&P 500 future contract. It's not for the conservative investor; all futures contracts have built-in leverage that increases risk, making for a greater profit potential but also greater possible losses. Futures tend to trade more often and in larger quantity than ETFs, though, so there are more opportunities to buy and sell over the course of a day.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

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