Many Exchange-Traded Funds are Not All They're Cracked Up to Be

I own shares in one exchange-traded fund, iShares Dow Jones U.S. Telecommunications Sector Index Fund (IYZ). I picked up the shares with free money from a Sharebuilder bonus, and since it was free money, I decided to attempt to choose an investment narrower than my typical investing philosophy would normally allow. Rather than a broad stock market index fund, I selected an industry that I thought would have great prospects for the 21st century.

For a while, ETFs became a favorite investment vehicle in the financial media. In the most basic form, ETFs are like index mutual funds. They benefit from low turnover, little tax liability, and low management fees. You can trade ETFs like stocks with a similar transaction fee. If you have a lump sum to invest for the long-term, the larger the lump sum investment, the smaller the fee is as a percentage of the assets.

According to Money Magazine, Wall Street is taking advantage of the popularity and frugal reputation of ETFs by creating an increasing number of these investments with higher turnover and fees.

Like index mutual funds, ETFs were designed to track traditional market benchmarks with long track records, like the Dow and the S&P 500. But to stand out from their rivals, lately providers have been cobbling together portfolios based on custom-designed indexes they hope will beat the market’s performance…

No question, traditional index ETFs are still dirt cheap, typically charging 0.20% or less. Yet the average expense ratio for ETFs overall is much higher — 0.53% of assets vs. 0.35% in 2002. What’s the deal? Newer ETFs with complex strategies tend to incur higher management and transaction fees.

IYZ falls right below the industry average with a total expense ratio of 0.48%. What have I received for this fee so far? I funded the account on August 9, 2005 with $50. As of today, after reinvesting dividends, my account is valued at $46.99.

Would I have been better off with VOX, Vanguard’s equivalent ETF? It appears that the two funds follow each other closely, but Vanguard carries a slight advantage. The lower expense ratio (0.23%) seems to account for Vanguard’s better performance. That slight advantage could account for a significant difference between the two funds’ performance if I hold onto the account for decades.

Despite recent poor performance, I believe the telecommunications industry is a great choice for the next century or so. I don’t mind “timing” the market with a free $50.

The best investment in 10 years: Get in while you can