Low Expense Ratio ETFs: A No-Brainer

Posted on October 4, 2012 at 12:11 PM PDT by

Hard on the heels of a decision to slash the already low expense ratio of its own exchange-traded funds (ETFs), money manager Charles Schwab is out with a detailed survey of its customers that clearly shows why: Investors care about cost. Specifically, they care about getting a very low expense ratio.

In its latest ETF Investor Study, Charles Schwab talked online with more than 1,000 individual investors between the ages of 25 and 75 with at least $25,000 in investable assets and some familiarity with ETFs.

ETFs are funds that buy and hold all of the assets in a given index — bonds, stocks or other securities — with the aim of returning market-matching performance at a very low expense ratio. They were introduced in U.S. markets only in 1993, but the low expense ratio quickly made them popular.

Schwab is a giant. It had $142 billion in assets on its platform as of Aug. 31, the firm says. Of that total, $7.2 billion is in low expense ratio Schwab ETFs, clearly a number Schwab would like to see increase at the expense of its competitors.

Schwab already offers its house-brand ETFs commission-free, in addition to the expense cost reductions it made recently. Interestingly, 58% of the survey respondents said a low expense ratio was “extremely important.” Just half said the same about commission costs.

low expense ratio ETFs

Tellingly, in a separate question, just 15% said that trading commission-free was “most important,” meaning that they would choose a firm based on this feature. Another 23% said that the only way they invest is by using commission-free ETFs.

Nevertheless, the remainder (62%) said that commissions were only one factor among many; that commissions didn’t matter; or that they weren’t sure.

In another interesting result, 44% of current ETF owners had less than a tenth of their investments in ETFs. Just 5% had half or more of their portfolio in the funds.

“It’s very exciting to see investors rally enthusiastically around ETFs as an essential part of their investing toolbox — but now we need to make sure that their knowledge about the use of ETFs fully matures as well,” said Beth Flynn, vice president of ETF platform management at Charles Schwab.

“Amen” to that, we say. Investor education is a huge topic, especially considering the challenges retirees and savers will face in the years to come.

And while commission-free trades are a help, investors are right to focus on the low expense ratio issue. In our view, commissions aren’t the problem. A well-designed portfolio does not require frequent trading. In fact, periodic, event-driven rebalancing means you might go long periods without changing positions much at all.

Let’s call commission-free trades a “nice to have,” since Schwab customers clearly already believe that. But a low expense ratio? That’s how you keep more of your money growing for you.

For instance, if you knew in advance that a specific actively managed fund would beat its benchmark, year in and year out, and do so by a wide enough margin to cover its fees and then some, well, you should buy that fund.

Therein lies the rub: Funds have good years and bad years. Star mangers come and go. Yet those fees pile up, regardless of performance. How many investors today are underwater on “hot” mutual funds that were supposed to outperform long into the horizon?

Low expense ratio ETFs vs. the mutual funds

Do you think those once-hot (and likely long retired) managers will offer up a refund anytime soon? Hardly. More likely, the worst of those funds got quietly tucked into larger, more successful cousins in the same fund family.

Their performance histories got erased, too, an effect the academics call “survivorship bias.” Essentially, companies stop talking about the losers and stop calculating in those results when publicizing their track record. Like it never happened.

Trading commissions matter. Don’t get us wrong. But truly the most powerful advantage an investor has — besides time and patience — is access to low expense ratio vehicles that are tax-efficient, simple, and designed to perform steadily. Steady performance leads inevitably to compounding, a proven path to wealth.

It looks like investors are starting to figure that out, and to demand more.