ETF management fees are better for investors that most fees on actively managed investments

ETF management fees are generally much lower that the fees on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

ETFs practice “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher costs.

ETF management fees for traditional ETFs

Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poors). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks change. They don’t attempt to pick and choose which stocks they think have the best prospects.

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This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.

We think you should stick with “traditional” ETFs. However, when an investment product faces booming demand as ETFs do today, investment companies try to expand sales by creating new versions of the underlying formula.

ETF management fees and new ETFs

Some new ETFs use a conventional stock-market index as a base, but add their own refinements. These refinements are tailored to current investor preferences or prejudices. That’s distinctly different from the traditional ETF, which simply aims to mirror an index. These newer, theme varieties may attract attention—and sales—but they frequently carry higher MERs.

In some cases, the new ETF may provide investment benefits but not consistently. In fact, it may hurt results, in the long run. The worst cases are bad enough to turn investor profits into losses. One sure result is that the higher MERs will cut into the value of your ETF portfolio every year.

Another drawback to the newer ETFs is how much easier it is for investors to act on an urge to invest in a specific stock or stock group without doing any messy and time-consuming research. If you want to invest in oil stocks or gold stocks or Swedish stocks or wind power stocks, or any of hundreds of other stock groups, you can act on that urge. However, that may not give you the best results.

Advice on ETF management fees

Overall, high management fees eat into an investor’s long term profits. That’s especially true with mutual funds. ETFs are among the more benign investment innovations of our time. Unlike other innovations, they don’t load you up with heavy management fees, nor tie you down with heavy redemption charges if you decide to get out before six years have passed. Instead, they give you a lower-cost and more flexible and convenient alternative to mutual funds.

The hidden risks of ETF management fees

Adding more features (sometimes referred to as “wrinkles” or “bells & whistles”) can make investing in ETFs attractive to a wider range of investors. Adding features also adds profit opportunities for the sponsoring institution.

For example, consider a typical ETF that gives you exposure to movements in an index of stock prices in an emerging market. This may appeal to investors who are thinking of investing in ETFs or other stocks in that market. But conservative investors may hesitate to buy, because they worry about currency movements in the emerging market. So the financial industry has come up with “hedged” ETFs.

The sales pitch is that you can profit from growth in the stock market of the emerging economy, but you avoid foreign-exchange risk because the ETF operator hedges against it. This conveniently overlooks the fact that hedging costs money.

Hedging costs will vary, depending on conditions in the foreign-exchange market, and on how an ETF carries out its hedging program. These fees can double or triple the typical 0.30% to 0.70% ETF management fee.

You’ll need to dig deep to find out how much you pay for an ETF’s hedging feature. But you can be sure that the placing of each new hedge provides a profit opportunity for the ETF sponsor.

Our view: simple is better. If you want to invest in something like emerging-economy stocks, limit your stake to a point where you can accept the associated foreign exchange risk. If you buy an ETF, choose a “plain vanilla” unhedged version.

Or, to adapt yet another old investor saying, “If the foreign-exchange risk on your emerging-market investments keeps you awake at night, sell down to the sleeping point.”

Have you found ETF management fees easier to deal with than the fees of other investments? Share your ETF investing experience with us in the comments.