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Forget Mutual Funds, Buy The Low-Cost Route Instead

 February 21, 2013 10:33 AM


(By Michael Vodicka) There are very few ways to score guaranteed, no-risk returns in the market. But I am going to share an incredibly simple strategy that few are using and even fewer understand that can help investors do just that.

With the S&P 500 failing to regain its high from more than 13 years ago, fees and expenses have never been more important for total returns. But there are far too many investors that continue to absorb completely unnecessary fees that chip away at those precious returns.

I am talking about mutual funds. Mutual funds are one of the biggest rip offs in financial services. Not only do 84% of actively-managed mutual funds under perform their benchmarks, they are also incredibly expensive, usually carrying annual expenses anywhere from 1%-3%.  In a world of slow economic growth where leading fund managers like Bill Gross say "the new normal" on stock returns is 4% annual, those high fees deliver a devastating blow to an investor's ability to grow their account.

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A far better way to invest is with ETF's (exchange-traded funds). ETF's offer a number of advantages over mutual funds; not only are they less expensive, with expense ratios as low as .10%, they also offer more transparency as listed securities, making them more cost effective to trade than the typical $50 execution fee to buy or sell a mutual fund. These lower expense factors can have a profound effect on portfolio returns in a low-return environment.

And although domestic, equity mutual funds still hold more than $11.5 trillion in assets; investors are beginning to get the message. 2012 was a horrible year for the mutual fund industry, with $147 billion in domestic, equity-focused outflows, while $121 billion flowed into U.S.-focused stock ETF's.

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If you are one of the investors waking up to the reality that mutual funds are a huge rip off, here are 4 critical things you need to know about an ETF when making your next great investment.

4 Things Every Investor Needs to Know about ETF's

Expense Ratio

This is an area where ETF's absolutely crush mutual funds. Look for ETF's that have expense ratios that are either in line with or below their category average. Although my premium newsletter, the "iStock Growth Trader", a biweekly newsletter that provides access to all my best trading and investment ideas is focused mostly on stocks, when we do use ETF's, we will definitely pay close attention to expense ratios to pump up our gains.

Average Daily Volume

Plenty of liquidity reduces price slippage when executing buy and sell orders.

Assets Under Management (AUM)

New ETF's are being launched all the time. New ETF's are generally more risky because of lower AUM (assets under management) and higher spreads. ETF's with higher AUM also tend to have lower expense ratios.

Tracking Quality

Some ETF's use derivatives to track their benchmarks, making them vulnerable to "contango," a factor that can cause serious price erosion for investors when fund managers have to pay up to roll into front month contracts. This is the biggest risk to ETF investors and something that should be looked at very closely before investing in any ETF.

Downside: As mentioned directly above, ETF's linked to derivatives are a big threat to investors due to contango and price slippage.

Benefit: Mutual funds are a huge rip off. ETF's offer a much more cost effective method for investing that can lead to big gains for your portfolio by minimizing expenses.

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