Fees Matter: We Show Off Low-Cost ETFs That Undercut Mutual Fund Expenses

Following a hot investment trend is typically an express ticket to disappointment. But the explosive growth in exchange traded funds (ETFs) is a bandwagon well worth joining.

ETFs have been around for 20 years, but since 2007 total ETF assets have doubled from $608 billion to $1.3 trillion at the end of 2012. Granted, old-fashioned mutual funds are still the big gorilla, with $13 trillion in assets, but that pile of dough has grown just 8% over the same stretch.

Long-Term Mutual Fund Flows Chart

Long-Term Mutual Fund Flows data by YCharts

What’s remarkable is that while mutual funds are the mainstay option within 401(k)s and other employer-provided retirement plans -- providing a steady infusion of cash for the mutual fund industry -- ETFs are still an anomaly within those retirement plans.

Morningstar reports that total net inflows into ETFs hit $191 billion in 2012. Net inflows for December alone were $37.7 billion. Another $28.6 billion came in this January; Morningstar says that two-month haul is an all-time ETF record.

With annual fees that can be one-tenth what traditional mutual funds charge, low-cost ETFs provide a shot at much better net (after expense) returns. In a new normal world where returns are expected to be muted, forking over less in fees becomes an increasingly important investment strategy.

For the fee conscious investor, here’s an all-star list of miserly ETFs among key asset classes:

The Vanguard S&P 500 ETF (VOO) gets you insta-diversification into the leading U.S. blue chip index for the insanely cheap cost of 0.05% a year. That compares to a typical annual expense charge of 1% or so for actively managed stock mutual funds. Sure, if the active manager gave you better performance the fee would be worth it, but reams of data show most managers don’t beat their benchmark index in a given year, let alone consistently over multiple years.

If you want a truly one-and-done investment to blanket the entire U.S. stock market, the Vanguard Total Stock Market ETF (VTI) tracks the broadest of indexes that includes microcaps all the way to mega caps, and charges just 0.06% a year in expenses. The Schwab U.S.Broad Market ETF (SCHB) has the same broad purview, and its annual expense ratio is also just 0.06%.

These two broad exposure U.S. stock ETFs track different indexes (Vanguard has historically tracked the MSCI Broad Market index but is currently migrating to a different index to further reduce management expenses, while Schwab follows the Dow Jones U.S. Broad Market index.) Still. The five largest holdings in both ETFs are identical: Apple (AAPL), Exxon Mobil (XOM), General Electric (GE), Chevron (CVX) and IBM (IBM). In the early going this year, only General Electric and Chevron are outpacing the 3.7% gain for the S&P 500, and Apple is uncharacteristically acting like a dead weight.

AAPL Chart

AAPL data by YCharts

Vanguard’s MSCI EAFE ETF (VEA) charges 0.12% a year for exposure to foreign developed market stocks. The ETF is also in the midst of a transition to a new index -- again to reduce costs even further -- which may cause some tax issues as the portfolio is rejiggered. A compelling alternative is the new iShares Core MSCI etf (IEFA) with an 0.14% expense ratio.

For bond investors, Schwab U.S. Aggregate Bond ETF (SCHZ) tracks the Barclays Aggregate bond index of U.S. high grade and government bond issues. Its 0.05% annual expense charge is some relief for income investors already facing abysmally low bond yields. The most successful new ETF last year was Pimco Total Return (BOND) which already has $4 billion in assets. Manager Bill Gross stomped all over the bond indexers since the fund launched in late February of 2012:

SCHZ Total Return Price Chart

SCHZ Total Return Price data by YCharts

While the vast majority of ETFs are passive index-huggers, the success of Pimco Total Return bond ETF is sure to usher in the next revolution in ETFs: actively managed portfolios. At a price. The annual expense ratio for Pimco Total Return is 0.55%. While that’s well below what PIMCO investors in an identical mutual fund pay, it’s not exactly dirt-cheap among ETFs. In years of extreme outperformance like 2012 that’s easy to look past. Given that Pimco is the house that coined the “new normal” mantra of muted future returns, it bears watching going forward. Gross’ active golden touch needs to add an extra half a percentage point a year in performance over the Barclays Aggregate index to erase the ETF’s fee disadvantage over the Schwab Aggregate Bond ETF.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com.

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