How ETFs Offer “Free Money”
- If you invest heavily in mutual funds, your strategy may be costing you a lot more than you think.
- Today, Nicholas Vardy explains how to calculate your costs and utilize ETFs to earn what basically amounts to free money.
“A penny saved is a penny earned.”
– Benjamin Franklin
You’ve probably heard this bit of Ben Franklin’s wisdom before. But if you stop to think about it, you’ll realize that Franklin’s insight is not entirely correct.
That’s not his fault. After all, he coined this proverb before the era of personal income taxes. Because of taxes, today, a penny saved is more than a penny earned.
If your marginal tax rate is, say, 35%… A penny saved is actually worth about 1.5 pennies earned.
That amount may not sound like a big difference. But it means that if you save $10,000, it’s the equivalent of earning $15,384 before taxes.
An additional bonus? Saving money is also 100% risk-free.
Once you’ve saved that $10,000, no one can take it away from you.
In short, there is no better value than “free money.” And free money is exactly what ETFs offer.
Let me explain…
ETFs: A Source of Free Money
In a former life, I was a mutual fund manager. And I must confess, it shocked me how much the marketing guys charged our investors to invest in our funds.
There were two types of fees.
Shareholder fees consisted of sales commissions and other one-time costs when investors bought or sold mutual fund shares. These expenses included sales loads, redemption fees, exchange fees, account fees and purchase fees.
Then there were annual fund operating expenses. These helped pay my salary and bonus, as well as accountants, legal fees, marketing and the like.
The total annual fund operating expenses are expressed as a percentage of the fund’s net average assets. In my case, they amounted to about 1.5% of assets under management.
The funds I managed also had different classes of shares. A, B and C classes had different fee structures – all of which added to the cost of holding the funds.
So if you are a longtime investor, the chances are good that you may still be invested in a class of mutual fund shares that are costing you money.
Counting Up the Cost of Your Investments
Using a financial advisor and investing in mutual funds cost you a lot more than you think.
Let me take you through some examples…
Financial Advisor Fees
If your advisor charges you 1% a year on $1,000,000 – that’s $10,000 per year, or $833 per month. If you have a $2 million portfolio, you are paying $20,000 per year, or $1,666 per month.
Now, you may have a financial advisor who is worth it.
If she is there to talk you off the ledge during one of “Mr. Market’s mood swings” and keep you focused on your long-term financial goals… she’s already earned her keep.
But if she’s investing your money in expensive mutual funds offered by her own company, you might want to look into a fee-only advisor who does not have such a conflict of interests.
Mutual Fund Fees
The mutual fund business is a big moneymaker for investment firms. Let’s assume your investment portfolio consists exclusively of various mutual funds.
An average mutual fund costs 1.13% a year. That works out to $11,300 per year, or $942 per month. If you have a $2 million portfolio, you’re paying $22,600 a year.
This amount is in addition to what you’re paying your financial advisor.
The bottom line? If you have a sizable portfolio of $2 million or more, you are probably paying close to $50,000 a year to manage your investments!
Your New Strategy for Free Money
Here’s a no-risk way of putting thousands of dollars in your pocket: Conduct an investment audit, and restructure your portfolio.
I used to do this for my clients back when I was managing money. The process was both difficult and expensive. But, boy, was it worth it.
What was my primary strategy?
Dump the clients’ mutual funds and invest the funds in equivalent exchange-traded funds (ETFs).
I quickly earned my fees with the expenses they saved by investing in low-cost ETFs over a single year.
Your financial advisor may not like this approach. After all, she may be financially incentivized to keep you in specific financial products.
If so, it’s time to take your financial future into your own hands. Do your own research, and become a self-directed investor.
Back-of-the-Envelope Savings Calculations
Let’s say your investment audit saves you $25,000 annually in fees. Over time, this adds up to more than you think. At a marginal tax rate of 35%, saving $25,000 is equivalent to making about $38,500.
Instead of mutual funds, you could move your $1 million into a single low-cost ETF like the Vanguard S&P 500 ETF (VOO). This ETF charges an annual fee of 0.03%.
That works out to a total cost of $300 per year. It’s literally almost nothing.
Invest those annual savings back into the Vanguard S&P 500 ETF for 10 years, compound it at the S&P 500’s average annual return of 10.3%, and over 10 years, guess how much it will amount to?
A whopping $470,846. That’s all free money.
But let me add a word of warning…
Don’t take any of this as personalized investment advice.
When I did an investment audit for my clients, I took into account their specific investment objectives and tax implications of selling existing holdings, as well as many other factors.
My point here is to make you aware of the hidden costs of mutual fund investing.
About Nicholas Vardy
An accomplished investment advisor and widely recognized expert on quantitative investing, global investing and exchange-traded funds, Nicholas has been a regular commentator on CNN International and Fox Business Network. He has also been cited in The Wall Street Journal, Financial Times, Newsweek, Fox Business News, CBS, MarketWatch, Yahoo Finance and MSN Money Central. Nicholas holds a bachelor’s and a master’s from Stanford University and a J.D. from Harvard Law School. It’s no wonder his groundbreaking content is published regularly in the free daily e-letter Liberty Through Wealth.