We’ve previously spoken about the value of cutting out expensive ETF fees. Today, we’ll dive into what types of funds carry higher fees and why. With over 130,000 mutual funds and ETFs around the world, we certainly won’t cover every scenario, but hopefully, this will help you make smarter allocation decisions.
🧠 What you need to know
ETFs and mutual funds come in two flavors: active and passive. Actively managed ones are overseen by a team of professional investors and aim to follow a specific investment strategy. Because of this hands-on approach, they tend to incur higher fees. Passive funds, on the other hand, operate essentially on autopilot, tracking a specific index or sector.
While not the focus of today’s discussion, it’s worth noting that ETFs trade throughout a given day, while mutual funds only trade once a day at market close.
🎯 How do you choose which is right for you?
Actively managed funds have the potential to outperform a benchmark, thanks to the expertise of their managing teams. However, this also means the fund could underperform if the strategies don’t pan out as expected. In fact, data shows that most actively managed funds underperform against popular benchmarks, like the S&P 500. As with most things in finance, the details matter.
Take, for example, the ARK Innovation ETF (ARKK). This graph from the ARKK factsheet illustrates the fund’s performance:
As you can see, there were years where the fund (purple line) vastly outperformed the S&P 500 index (black line), but in aggregate since 2015 the fund has been underperforming.
ARKK charges a 0.75% expense ratio. So, for every $10,000 invested, you pay $75 per year to ARK Funds to invest in it. In 2021, you probably would have been more than happy to pay the $75. Today, given the underperformance, you may be less happy. Perhaps over a long enough time period the fund will outperform. This is part of the bet you are making in choosing an actively managed fund – you are seeking the opportunity for upside beyond just what the market offers and putting your trust in the team that runs the fund.
Passive funds, on the other hand, seek to mirror a particular index, basket of stocks, or sector. They don’t require nearly as much management by a professional team of investors, as they don’t decide what goes in and what comes out of the fund.
Let’s take two types of passive ETFs as examples:
- Vanguard 500 Index Fund ETF (VOO): The returns of the fund are nearly identical to the returns of its benchmark, the S&P 500, each and every year. The fund’s expense ratio is 0.03%, or $3 each year for every $10,000 invested.
- Invesco QQQ (QQQ): It tracks the Nasdaq 100, the largest companies by market capitalization listed on the Nasdaq. The fund’s expense ratio is 0.20%, or $20 each year for every $10,000 invested.
So as you can see, ARKK charges a premium management fee compared to the two passive funds. During certain years it was worth it, but in other years it underperformed and it would have been better to invest in a passive fund.
As an investor, you have to weigh the tradeoffs and determine what is best for you.
🤝 How can Mezzi help?
- Automatically evaluates your current fund investments.
- Shows potential savings on fund fees .
- Suggests alternative funds with lower fees.
- Helps you understand your allocation to ETFs and mutual funds.
