The Hidden Costs of ETFs
One thing we tell you to be on the lookout for when making your investment decisions is cost, because they could eat into your overall rate of return. In some cases so-called low cost investments may actually cost up to an additional 4.0%!
First, let’s talk about Exchange Traded funds. We call them ETF’s. These are securities that track an index, or a commodity, or bonds, or a basket of assets like an index fund, but unlike a mutual fund, they’re bought and sold like a common stock on the stock exchange. ETFs are popular with index-tracking investors, and they tend to have a reputation as efficient, potentially low-cost vehicles.
With ETFs, many people think of market cap-weighted ETFs like the S&P 500, which have an investing mandate to buy the largest companies and work their way down. By paying attention only to size, important things like company fundamentals may get pushed out of the picture.
What this can lead to is investors owning shares of companies by way of an ETF that, had they looked at each of these stocks individually may have taken a pass based on their underlying fundamentals.
I came across an interesting article recently that highlights this point. According to research published in the Pension and Investments Newsletter, there are two factors that contribute to added costs that investors may not be aware of: First, there is the cost of dilution in stock price relating to the company’s executive compensation plan. Second, is the cost relating to the annual share buyback programs of certain companies. What they claim is happening is that certain companies may be issuing annual share buyback programs to offset the dilution of their executive compensation plans. Together, the author calculated that these expenses add up to an average 4.1% annually to the costs of owning an index fund built to mimic the S&P 500. Would you invest in a company if you knew your performance could be dragged down by 4.1% annually?
Well, this isn’t to say that ETFs are bad – for the appropriate investor, they can potentially add value. And we do use them in our portfolios. What we prefer however is factor-driven strategies that focus on fundamentals over market cap weighted strategies. These can be in the form of a passively managed ETFs or actively managed individual stock portfolios.
The point is that it’s not necessarily the size of the company that matters, but rather the underlying fundamentals.
Before investing, carefully consider an exchange-traded fund’s investment objectives, risks, charges, and expenses. To obtain a prospectus or summary prospectus, which contains this and other information, call your financial advisor. Read the prospectus carefully before investing.
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
Information presented should not be considered specific tax, legal, or investment advice. You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal.
The S&P 500 Index is an unmanaged index and includes a representative sample of large-cap U.S. companies in leading industries. An investment may not be made directly in an index.
Raymond J. Lucia Jr. is chairman of Lucia Capital Group, a registered investment advisor and CEO of its affiliated broker/dealer, Lucia Securities, LLC, member FINRA/SIPC. Registration with the SEC does not imply a certain level of skill or training.
No client or prospective client should assume that the information contained herein (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group, its investment adviser representatives, affiliates or any other investment professional.