Investors Move to Lower Costs, Latest Vanguard Study Finds

There's been a big shift from the absolute-return focus of the '80s and '90s; still, poor market timing can hurt results for investors using low-cost products today, experts caution.

A new Vanguard study finds that lower-cost mutual funds and ETFs have attracted the predominant portion of investor dollars over the past decade. Experts caution, though, that poor market timing and other factors can mitigate the benefits of these lower costs.

In"Costs Matter: Are Fund Investors Voting With Their Feet?" Vanguard found that in five fund categories, investors favored funds with lower expenses, directing between 55% and 93% of cumulative net cash flow to the lowest-expense quartile of funds, the fund company said in statement .

"It is clear from our analysis that investors are increasingly gravitating toward low-cost funds and ETFs," said Francis Kinniry, Jr., principal, Vanguard Investment Strategy Group, in a press release. "The trend to low-expense funds is very encouraging."

Kinniry says that the growing popularity and availability of index funds and index-based ETFs has likely encouraged the move to low-cost products. He also notes that a similar shift has taken place among actively managed funds, as lower-cost active equity funds attracted more assets relative to their higher-cost counterparts.

The Vanguard analysis focused on monthly fund-level cash flow data from Morningstar for the 10-year period ended December 31, 2009.

The study also found that:

-Some 80% of fund assets are held through financial advisors and corporate retirement plans.

-In the advisor market, a move from a transaction-oriented, commissioned-based model to a fee-based model likely abetted the low-cost trend.

-By contrast, the historically generous stock and bond returns of the 1980s and 1990s resulted in investors focusing on high absolute returns and paying little attention to costs.

Costs vs. Timing

As investors pay more attention to cost, they should be careful about market timing and other factors, points out Frank Holmes, head of U.S. Global Investors. "Research shows that the tradability of ETFs can actually be a costly curse in terms of real returns," he wrote in a recent blog.

For example, the average small-cap value ETF investor achieved a return 4.3 percent below what the ETF returned over the same five-year time period.

This happens by buying high and selling low, Holmes explains. In contrast, the average small-cap value mutual fund investor return was only 0.2 percent below the fund's performance.

The five-year returns for index mutual fund investors were higher than the returns for the ETF investors for each of the nine style boxes.

An examination of the five-year returns of more than six dozen ETFs across a range of asset classes by the founder of Vanguard Group concluded that the ETF investors made 18 percent less than the returns of the ETF itself because of the investors' trading activity, Holmes adds, after reviewing analysis at MoneyWatch.com.

Unlike mutual funds, ETFs can trade at a premium or discount to their net asset value (NAV). When an ETF investor buys at a premium, he overpays for the asset. Likewise, if he sells at a discount, he receives less than the asset is worth.

"These premiums and discounts can be wide, especially on days with big NAV changes, and the premiums/discounts can swing very quickly from one extreme to another," Holmes said in his blog.

His conclusion: "There's no such thing as a free lunch when it comes to investing. ETFs have relatively low expense ratios compared with actively managed funds in the same sectors, but that doesn't mean that in the end an ETF costs less to own or that an ETF generates better returns. They can be expensive to trade on volatile days and the events of May 6 uncovered some new weaknesses."

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