ETF review: a good retirement strategy or investment?
Many years ago when I entered the industry, ETFs were not very popular. Many people had never heard of or used them, and they really only began to gain ground and—truly—skyrocket over the last five years or so. Today we’ll discuss the reason why the current landscape is saturated with ETF investments, why they're so powerful, and how they can help your portfolio in retirement (or leading up to retirement).
First of all, let's dissect what an ETF (Exchange Traded Fund) is: a basket of securities that's traded on an exchange just like a stock or mutual fund. As we examine ETFs, though, one distinction they boast is that their share price fluctuates throughout the day as they are bought and sold. This is very different from mutual funds, yet exactly how stocks are traded. So, if you're considering the price of, say, an S&P 500 stock—for example, Coca-Cola—you will see Coke’s stock price go up and down, up and down, mimicking all other stocks on the exchange. These stocks fluctuate per the demand of buyers and sellers on any given day. Well, ETFs operate in the same fashion. They also hold all types of investments including stocks, bonds, gold, global stocks, global bonds, commodities, and precious metals. In this way, you're really not that limited with what ETFs can afford you. They offer a tremendous opportunity to break into a particular asset class, leading into the next advantage of ETFs.
ETFs are very, very reasonably priced compared to mutual funds, resulting in an explosion in ETF popularity over the last decade or so. In 2003, $0.15 trillion was invested in ETFs…$0.15 trillion! That number more than quadrupled by 2007 when ETFs reached $0.61 trillion, so in other words, $610 billion was invested in ETFs by 2007. In the ensuing years, EFTs continued to grow: breaking the trillion-dollar mark for the first time in 2011 and hitting $1.3 trillion the following year. As we examine the continued growth of ETFs, they went on to surpass $2.5 trillion in 2016 and by the end of 2020, more than doubled to $5.4 trillion (truly showing just how popular they've become).
Above all else, $5.4 trillion is a tremendous amount of growth. Percentage wise, it's astronomically high for this particular type of wrapper over the last decade-plus. Simply put, no other investment vehicle has mirrored the growth rate of ETFs over the past 10 years—an extremely impressive feat.
Yet even with all that amazing growth, ETFs still fall well short of mutual funds, which reflect roughly $24 trillion and approximately 8,000 funds. I personally believe ETFs will continue to outpace the growth of mutual funds in the coming decade and eventually become so popular that they will surpass them together.
The Fees Of ETFs
The reason why? They’re just so incredibly low-priced, offering investors an opportunity to enjoy cost-effective exposure to a big basket of securities (whereas mutual funds do not).
The average mutual fund expense is between 0.5% and 1%, a great deal higher than the average ETF expense of around 0.53%. Considering the average US equity mutual fund, this really averages out to around 1.42%. Further, if you look at the expense of the average ETF, it's 0.53%. As such, the cost is dramatically less than mutual fund investments and their expense ratios. If you consider how much less it is, it’s a pretty substantial number when you realize that ETFs are about 63% less expensive than mutual funds: and hence, the number-one driver of ETF popularity.
As we watch ETFs continue to grow, it becomes quite evident that they're not going anywhere. Many mutual funds out there are actively managed. There's a lot of movement and stock research performed, with some mutual fund companies and investors apt to add market to the value—and a history of being able to do so. Perhaps not in consecutive years, but over a 10- or 15-year time period, some research houses are able to add value above and beyond how the indexes perform. Most cannot, but some in fact can. In scrutinizing the largest mutual fund companies, we notice that Vanguard and Charles Schwab are No. 2 and No. 3. Black Rock is No. 1. Yet in considering the former two, they both have approximately $7 trillion in global assets.
Both of these companies have very low-cost mutual funds. So as we see ETFs approach $6 trillion, it’s worth noting that two of the top three largest mutual fund companies are very low cost in nature—with many parallel funds and expense ratios when compared to the type of underlying indexes they're investing in: driven mainly by cost. Cost is extremely important, generally creating the largest mutual fund companies and leading to the increased popularity of ETFs (incentivizing investors with low prices).
Why are low costs so important? Well, the answer is obvious. They in fact reflect a correlation with Morningstar research that each quintile of performing mutual funds is directly associated with the mutual fund’s long-term performance and expense ratio. So in general, if you observe the fifth quartile, its average expense ratio is less than that of the fourth quintile (and the fourth is less than the third). The average performer is the third quintile—the one in the middle.
When you see a 100% direct correlation between the average expense of mutual funds and their performance, it's very compelling for investors to invest in low-cost mutual funds and ETFs. ETFs on average, as we already discussed, are 63% less expensive than mutual funds: a major consideration for investors as they examine the growth and future popularity of these investments.
Some mutual funds in fact charge high fees, but their performance is justified because they've managed to outperform the market—but that's not the norm. It's very difficult to outperform a Vanguard or Schwab mutual fund or an ETF, as most of these money managers are in the same exact category: for example, let’s say small cap versus a Vanguard small cap mutual fund, or a small cap ETF.
Wrapping up, we regularly recommend and use ETFs. We also rely on low-cost mutual fund companies like Charles Schwab, Dimensional, and Vanguard when tackling our stock and bond recommendations. For our larger accounts for tax purposes, we use individual stocks as our money managers have 10- and 15-year track records of outperforming the indexes they're competing against. Furthermore, this is even more affordable than ETFs and mutual funds because an individually managed stock portfolio boasts a zero annual expense ratio. More detailed information surrounding that is best saved for another article, but a brief mention sheds some light on what we're doing with our clients.
Schedule a Retirement Ready Success Call
If you'd like to set up a call wherein my team and I can review and analyze your portfolio, please do so! We welcome you to click on the link provided to set up a “retirement ready” success call. We'll go over where you are now, where you want to be, and I'll share some tips and strategies my clients are employing with regards to how ETFs and mutual funds fit into their retirement portfolio. There is no cost or obligation. Looking forward to hearing from you!