Is Investing a House of Cards?

By:  H. Clark Gaines, Jr.    (On Twitter @Clarkgaines)

 

“Pay attention to the fine print.  It’s more important than the sale price.” – Francis Underwood

Frank Underwood

 

 

 

 

 

 

 

 

 

Francis Underwood, the smooth talking Congressman played by Kevin Spacey in Netflix’s hit show, House of Cards, is never short on crafty one-liners.  Seldom though does he give us one with so many parallels to investing.  In today’s investing climate, there’s a lot of hype about Exchange Traded Funds (ETFs).  The assumption is that mutual funds are slow, expensive, antiquated means of investing while ETFs are liquid, transparent, and a cheap way to access a market sector or index.  Some broker-dealers offer teaser rates for trading ETFs with no transaction costs.  Imagine that, a “free” way to invest in the market!

Most of our clients have heard us say, there is no free lunch in investing.

Just because something appears free, nearly free, or even “cheap” doesn’t mean that is the case. Transaction costs are only one piece of a complex investing puzzle.

Often the internal expenses of an investment are more substantial than the transaction costs to buy or sell it. These are the expenses that an investor pays the investment company for the management and daily operation of a mutual fund or ETF. This includes the cost of salaries, office expense, marketing departments, and even paperclips. Internal expense ratios are deducted daily from the net asset value (NAV) of the fund, so they don’t show up explicitly on a monthly statement. This “hidden” nature of internal expenses often leads investors to overlook the true cost of the investment. Fund companies selling ETFs know that what investors think is a “free” way to access the market, is really a goldmine for earning internal expenses.  High internal expenses can erode the long-term value of your investment over time.

While it’s true that ETFs often have lower internal expenses than mutual funds, an investment decision should not be made on cost alone. A “free” ETF may seem like a no brainer, but there are a vast number of additional factors to consider before selecting an investment. ETFs have gained popularity over the past 15 years, and there are now more than 4,000 ETFs with billions of assets under management.  How is an investor to choose among thousands of ETFs? In addition to ETFs that track the performance of well-known commercial indexes – SPY (S&P 500 Index), EFA (MSCI EAFE Index), AGG (Barclays Aggregate Bond Index), there are ETFs for every esoteric slice of the investable market imaginable – VXX (VIX Short-Term Futures[1]), UNG (US Natural Gas), MOO (Global Agribusiness), TBT (2x Short 20 Year Treasury Bonds)! One could argue that instead of making investing easier for individual investors, ETF product marketing has made things more confusing. Speaking of Underwood’s reference to fine print, the prospectus for the ProShares UltraShort 20+ Year Treasury ETF (TBT) is 800 pages long!

Lower expenses do not necessarily lead to better investment outcomes. However, there are times when a passively managed, low-cost, tax-efficient ETF is the right investment for a particular part of a portfolio. Bottom line – every investment selection should be made by considering a wide range of factors affecting that investment’s performance and its role in the overall portfolio. While price is certainly important, it’s not the entire picture. Cheap or “free” ETFs may be appealing, but Francis Underwood will tell you to look under the hood. The fine print may be where the real costs lie.

H. Clark Gaines, Jr.  (on twitter @Clarkgaines)

 

 


[1] VIX is the CBOE Volatility Index® a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.