Dan Hallett is the director of asset management for Oakville, Ontario-based HighView Asset Management Inc.
A recent Globe and Mail article suggested that investors can improve their returns by replacing mutual funds with exchange-traded funds. This argument hinges on minimizing fees with ETFs, thereby adding fee savings (over more expensive mutual funds) to bottom line returns.
But if you think that dumping your mutual funds for ETFs is the path to riches and higher returns, think again.
The average mutual fund investor pays about 2 per cent annually in management fees, operating expenses and taxes. The average investor in TSX-traded ETFs pays closer to 0.4 per cent a year. The average potential cost savings, then, are about 1.6 per cent per annum. But this is only available to do-it-yourself (DIY) investors. Otherwise, investors who need professional advice have to pay for it either through higher product fees or fees paid to an adviser in addition to ETF expenses.
The 2 per cent average mutual fund fee generally includes compensation for advisers, whereas ETF fees do not include the cost of obtaining advice. So-called fee-based or fee-only advisers charge a fee equal to 1 per cent to 1.4 per cent of your portfolio value. Add that to ETF fees and taxes and you've got total annual fees of 1.5 per cent to 1.9 per cent annually. Wave goodbye to that fee advantage.
For those who need advice, there is great value in the design of a custom asset mix. In addition, selecting a handful of ETFs from among the 1000-plus trading in North America is challenging for most. But if you expect to fully benefit from low ETF fees, you'll have to jump into the driver's seat of your portfolio and become a DIY investor.
A problem for some DIY investors is that there is a significant barrier to realizing the full cost benefits of ETFs. In the hands of DIY investors, the ETF fee advantage usually vanishes thanks to poor portfolio construction and frequent trading.
Of all of the "indexed" or ETF portfolios that I have reviewed over the past 16 years, only two were focused on obtaining the broadest diversification possible at the lowest possible cost. This boring strategy is key to successful indexing. But investors can't seem to stop buying all of the market's slices and dices that ETF sponsors have packaged for investors. This not only violates the basic tenets of successful index investing, but it also sets the stage for more return-detracting behaviour.
I estimate that investors in stock mutual funds tracked by the Investment Funds Institute of Canada tend to hold their funds for an average of 6 to 7 years. (Note that this average is dollar-weighted, not based on an average of each investor's holding period.) ETF investors, on the other hand, only hold for a fraction of the time of their mutual fund investor peers. And there is strong evidence suggesting that the more frequently individuals trade, the less money they make.
Brad Barber, Yi-Tsung Lee, Yu-Jane Liu and Terrance Odean studied all the trades made on the Taiwan Stock Exchange from 1995 through 1999 for a 2008 paper entitled "Just How Much Do Individual Investors Lose by Trading?" They found that individuals lost a total of almost 4 per cent annually to trading fees and poor timing (while institutions profited). Similar research on U.S. investors pegs the "trading losses" at about 2 per cent per year. This is consistent with past Barber and Odean stock trading studies.
In a 2000 paper, they found that the higher an investor's trading frequency, the lower the investor's net returns.
My own research over the past decade strongly suggests that more volatile investments lure more investors into making ill-timed trades. But there is hope. Investors can benefit by paying attention to total fees, regardless of the type of investment. Investors that can develop an awareness of the real impact of brokerage costs and ill-timed trades can change their performance-detracting behaviour.
Less aware investors, however, may want to think twice about jumping head first into the ETF world.
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