Every industry has its loss leaders, and the investment world is no different. The theory is that you will go to the store for the $12 turkey and stick around to buy dressing, cranberries, juice, pies and two kinds of potatoes.
In the investment world, the role of the cheap turkey is played by broad stock index exchange traded funds. While investment firms say they make money on even low-fee funds, their profit margins on these products have been narrowing.
There's been a bidding war among issuers of exchange traded funds that mimic large stock indexes like the Standard & Poor's 500 or the Wilshire 5000 stock index. Companies including Blackrock, Vanguard, and Charles Schwab have been competing to offer investors the lowest cost shares possible on these products. Right now, Schwab — which will begin offering pre-mixed portfolios of ultra-low-cost ETFs early in 2015 — is winning.
Their theory? You'll come in the door for the index ETF and stay for the more expensive funds, the alternative investments, the retirement advice.
"We believe we will keep that client for a long time," said John Sturiale, senior vice president of product management for Charles Schwab Investment Management.
Investors, of course, are free to come in and buy the cheap TV and nothing more. Here are some points to consider if you want to squeeze the most out of low-cost exchange traded funds.
A few points don't matter, but a lot of points do.
"Over the long term, cost is one of the biggest determinants of portfolio performance," said Michael Rawson, a Morningstar analyst.
If you have a TD Ameritrade brokerage account, you can buy the Vanguard Total Stock Market Index Fund ETF for no cost beyond annual expenses of 0.05% of your assets in the fund. At Schwab, you can buy the Schwab U.S. Broad Market ETF for an annual expense of 0.04%. That 0.01 percentage point difference is negligible.
But compare that low-cost index fund with an actively managed fund carrying 1.3% in expenses. Invest $50,000 at the long-term stock market average return of 10% and you'll end up with $859,477 after 30 years of having that 0.05% deducted annually. Pay 1.3% a year in expenses instead (not unusual for a high-profile actively managed mutual fund) and you'll end up with $589,203. You'll have given up $270,274 in fees, according to calculations performed at Buyupside.com.
Don't pay for advice you don't need.
The latest trend in investment advice is to charge clients roughly 1% of all of their assets to come up with a broad and diversified portfolio — with index funds at their core. Why not just buy your own core of index funds and exchange traded funds directly, and then get advice on the trickier parts of your portfolio? Or pay an adviser a onetime fee to develop a mostly index portfolio that you can buy on your own?
You won't give up performance.
High-priced actively managed large stock funds as a group do not typically beat their indexes over time. Even those star managers who do outperform almost never do so year after year after year.
Build a broad portfolio.
Not every category of investment lends itself to low-cost indexing. You may do better with a seasoned stock picker if you're taking aim at small-growth stocks, for example. But you can make the core of your plan a diversified and cheap portfolio of ETFs at any of the aforementioned companies, and save your fees for those extras that will really add value — the gravy, if you will.