Over the last couple of months we have been discussing at great length the many benefits of ETFs and several ways we can use them in our active investing strategies to achieve results that outperform many, if not all, of the various fund managers.
The main benefits of ETFs to all investors include:-
- Ease of trading and flexibility
- Access is available from the same trading account using your existing broker
- Diversification
- The ability to reduce portfolio volatility
- Low cost
It is this last point that I am focusing on today to highlight the importance of reducing costs within our portfolios.
As Warren Buffett states in his 2014 report to Berkshire Hathaway shareholders:
Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game. There are a few investment managers, of course, who are very good – though in the short run, it’s difficult to determine whether a great record is due to luck or talent. Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship.
As an example, let’s assume you have $20,000.00 to invest and you decide to put it into a managed fund that charges 2% in expenses. This means that $400.00 of your initial investment goes to the fund manager, leaving $19,600.00 for investment into the fund. If we assume a compound annual return of 8% and make no allowance for tax, or ongoing annual fees, the total return on the initial investment over a 40 year period would be just short of $426,000.00.
Now, if we assume the $20,000.00 is invested into a low cost index fund ETF with an initial expense of 0.5%, we now have $19,900.00 invested in the market as only $100.00 has been paid in fees. The total return on this $19,900.00 initial investment over the same 40 year period at the same 8% per annum compounded is just over $432,000.00.
This difference in total return of around $6,000.00 isn’t huge. Imagine if the portfolio was $200k though? That’s $60k over the life of the portfolio, much more significant.
The real benefit comes over time when additional amounts are added to each fund every year AND we add in the fact that managed funds charge fees annually which are debited from your managed fund account regardless of the performance of the fund. The power of compounding in this case results in a significant financial advantage to using ETFs over managed funds. Little wonder that Buffett has made clear plans for the financial future of his wife after his passing …
“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
