Do you need to diversify your holdings? If you are not diversified to at least some degree, you are taking on risks that are unnecessary in nature. About 10 to 15 years ago the only real ways to diversify for the smaller investors was to own a variety of individual stocks and bonds. A second more accepted practice of smaller investors was to own an actively managed mutual fund or an indexed fund. Over the last ten years, exchange traded funds (ETF) have become extremely popular with investors of all sizes for several reasons.
In recent years actively managed funds have not necessarily outperformed their benchmark index while charging much higher management fees as compared to an indexed fund or ETF. In a recent report on performance of actively managed funds, three out of five large-cap funds did not outperform their benchmark. And small-cap funds had an even worse performance with three out of four failing to outperform their benchmark. And with the popularity of ETF’s it is creating a shift in investing with ETF’s now having over $2 trillion invested at the end of 2014 as compared to $4 trillion in mutual funds. And every year the gap between the two narrows as more investors are opting for ETF’s.
When deciding if you should invest in a mutual fund or an ETF one of the primary considerations is the cost of the fund itself. Actively managed funds that are designed to beat the market on average charge 1.14% in management fees a year. This means that for a $100,000 investment for any profits or losses in the fund $1,140 will go to the fund itself. In a passive fund that tracks an index, the management fees average about .35% or $350 a year, about 70% cheaper than the actively managed fund. Now compare those to an indexed ETF in say the S&P 500 the management fee is .05% or $50 a year. Compound those savings over a 20 or 30 year period and you are looking at tens of thousands of dollars in lost income. So when diversifying it is always a good idea to consider the investment first to see if it meets you needs and then take a close look at the management fees the investment charges. A cheap investment is not everything if the overall investment itself does not contribute to your diversification and investment plan. Both are critical to examine when deciding what to invest.
Another consideration that must be taken into account is the cost of transaction fees to buy and sell the investment. Many mutual funds can be purchased and sold commission free through the issuing company or a number of brokerage firms. If you buy in a larger block, this is not as big an issue as someone who invests in smaller denominations. When you invest in smaller denominations commissions can take a big portion of your investment as compared to buying larger blocks of a fund. In recent years, however, many issuing companies and some brokerage firms have started offering free transactions on certain ETF’s as well. Investigate what the investment fees or commissions will be on a fund prior to purchasing the fund. IN many instances, you can find a brokerage firm that will offer discounts or even free trades on a family of funds. The key here is to keep as much as you can invest instead of paying transaction fees.
Finally, ETF’s are more tax advantageous than mutual funds that are actively managed. In most actively managed funds, the turnover rate of assets can be as high as 40%. This means that the fund is actively buying and selling securities throughout the year and by doing this the fund creates a capital gain situation that is passed along to the shareholders in the form of taxes. ETF’s and indexed funds have a much lower turnover rate and by that create a lower or in many instances no capital gains situation within the fund itself. Taxes are always present when a fund or ETF makes a distribution of dividends to the fund’s owners.
It is now possible for even the smallest investor to diversify in an adequate manner through the use of ETF’s. As with any investment perform your due diligence on any investment prior to investing. If you need more information or have any questions feel free to contact me.
