Related topics: ETF, investments, commodities, stocks, savings
Any investor not living under a rock has some appreciation for why the ETF industry has been expanding. Intraday liquidity, enhanced tax efficiencies and a degree of transparency not available in many other structures explain the explosive growth over the past decade in both the number of ETF products and the assets invested in them.
But the big driver of the ETF expansion relates to expenses or, perhaps more accurately, the lack of expenses.
ETFs were originally designed, at least in part, to combat what Vanguard founder John Bogle has called the "tyranny of compounded costs." For investors who believe that security selection fails to consistently add value -- and there is a boatload of academic evidence that supports that theory -- paying for pricey, active management does little more than erode returns over the long run.
Most ETFs are passive, meaning they seek to replicate the performance of a specific benchmark. That means low overhead, which translates into lower fees for investors.
As competition among ETF issuers has heated up, many of the companies have sought to differentiate their products on the basis of cost. So while many of the newer ETFs are more targeted and sophisticated products -- and, as such, charge expenses above the industry average -- fees on many products have been cut in an effort to appeal to cost-conscious investors.
That downward pressure on fees has primarily targeted "plain vanilla" products, making it possible for investors seeking to construct a low-cost, buy-and-hold portfolio with a minimal price tag.
Just how cheap can it be to develop a well-balanced, all-ETF portfolio that maintains exposure to all the major asset classes?
We examined the cheapest ETFs to come up with a portfolio that includes broad-based exposure to domestic and international equities, fixed-income instruments and even commodities:
| Broad-based and inexpensive | ||
| ETF | Category | Expense ratio |
|---|---|---|
| Focus Morningstar US Market Index (FMU) | Multi-cap growth | N/A |
| Vanguard Europe Pacific (VEA) | International stock | 0.15% |
| Vanguard MSCI Emerging Markets (VWO) | Diversified emerging markets | 0.22% |
| UBS E-Tracs Dow Jones-UBS Commodity Index (DJCI, news) | Natural resources | 0.50% |
Focus Morningstar US Market Index
Focus Morningstar US Market Index (FMU) is part of a suite of recently launched FocusShares ETFs that aim to undercut competitors from an expense perspective.
It provides broad exposure to U.S. stocks in a single ticker. The underlying index consists of more than 1,500 individual securities, including large-cap, mid-cap and small-cap U.S. stocks. The index components account for the top 97% of U.S. market capitalization.
This ETF may be tilted toward large-cap stocks, but the wide net cast by the related benchmark ensures that investors can achieve exposure to small and midsize companies.
For investors with a Scottrade account, FMU can be traded commission-free, adding appeal to those interested in minimizing the cost of rebalancing.
Other low-cost ETF options for broad-based exposure to the U.S. market include Vanguard Total Stock Market ETF (VTI) (annual expense ratio: 0.07%) and Schwab U.S. Broad Market ETF (SCHB) (expense ratio: 0.06%.)
Vanguard Europe Pacific
Vanguard Europe Pacific (VEA) provides exposure to developed markets outside the United States. Among its holdings are more than 900 individual securities from more than a dozen markets, including companies listed in Western Europe, Japan and Australia.
This ETF is one of several products to target the EAFE region, encompassing Europe, Australia and the Far East, but it's by far the cheapest option. Like other Vanguard ETFs, it is eligible for commission-free trading to Vanguard brokerage clients.
A similar product is offered by iShares, but the iShares MSCI EAFE Index (EFA) charges a higher expense ratio, 0.35%.
Vanguard Emerging Markets
With more than $47 billion in assets, Vanguard MSCI Emerging Markets (VWO) is one of the largest exchange-traded funds available to U.S. investors. And this fund, which seeks to replicate the MSCI Emerging Markets Index, is one of the cheapest options for gaining exposure to developing economies. The ETF has more than 850 holdings; the largest country allocations go to China, Brazil, South Korea and Taiwan.
Its surge may represent the best evidence that investors are embracing low-cost ETFs. Vanguard Emerging Markets saw inflows of about $1.9 billion during the first quarter of 2011, a period in which iShares MSCI Emerging Markets Index (EEM, news) had outflows of more than $9 billion.
Both ETFs are linked to the same index, but VWO (0.22%) maintains a significantly lower expense ratio than EEM (0.69%).
UBS E-Tracs Dow Jones-UBS Commodity Index
UBS E-Tracs Dow Jones-UBS Commodity Index (DJCI, news) is a commodity fund offering exposure to a basket of futures contracts, spreading exposure across nearly 20 different natural resources. The largest target weights are to crude oil (14%), natural gas (12%), gold (9%) and soybeans (8%), with all types of commodities represented in the underlying DJ-UBS Commodity Index Total Return.
It is structured as an exchange traded note, or ETN, and charges just 0.50% in annual expenses, considerably less than many similar products. The fund may be the ETF industry's best-kept secret. At the end of March, it had just $27 million in assets.
The iPath DJ-UBS Commodity Index (DJP) is linked to the same index but charges an additional 25 basis points in expenses annually. The more expensive fund finished March with nearly $3.3 billion in assets.
This article was reported by Michael Johnston for MoneyShow.com.
