10 Bullets Aimed at the Heart of Mutual Funds (NYSE:SCHX, NYSE:SCHB, NYSE:SCHZ, NYSE:VOO, NYSE:VOO)

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December 3, 2012 12:28pm NYSE:SCHB NYSE:SCHD

Wouldn’t it be great to be a mutual fund executive? What could be better than sitting on a pile of money that pretty much sticks with you through up and down markets, churning out a steady cash flow? According to the Investment Company

Institute, there are more than $5.7 trillion in stock mutual funds alone. There are 650 firms that sponsor the thousands of U.S. mutual funds, but five giant companies control 40% of assets.

Fund groups such as American Funds, T. Rowe Price and Franklin Templeton have the advantages of scale, strong brands, long-term performance and exceptional marketing material and customer service.

Is there anything that keeps mutual fund execs up at night?

You bet.

The biggest challenge to mutual funds is exchange-traded funds, or ETFs. These funds that trade on an exchange have grown quickly over the last decade to approach assets of $1 trillion. Compared to mutual funds, ETFs usually offer investors a combination of better transparency, tax-efficiency and lower fees.

The low fees advantage is critical for long-term investors, especially given the less-than-stellar performance of the vast majority of mutual funds.

And as competition has spurred a bit of a price war amongst ETF sponsors, fees have been driven down to close to zero while the average fee for the mutual fund industry remains above 1%.

Here are 10 bullets aimed at heart of mutual fund industry:

  • U.S. Large-Cap ETF (NYSE:SCHX): This fund offers exposure to the largest 750 U.S. securities while charging just 0.04%.
  • U.S. Broad Market ETF (NYSE:SCHB): This fund is a basket of the 2,500 largest stocks listed on U.S. exchanges. It also has a fee of 0.04%.
  • U.S. Aggregate Bond ETF (NYSE:SCHZ): This Schwab fund tracks U.S. investment grade bonds and charges just 0.05%.
  • S&P 500 ETF (NYSE:VOO): VOO competes with SPY, and is closing in on assets of $6 billion with fees of just 0.05%.
  • Total Stock Market ETF (NYSE:VTI): Vanguard’s VTI offers exposure to the broad U.S. market while charging just 0.06%.
  • US Dividend Equity ETF (NYSE:SCHD): Schwab’s SCHD is a basket of dividend payers from the Dow Jones U.S. Broad Market Index and charges just 0.07%.
  • U.S. Mid-Cap ETF (NYSE:SCHM): This mid-cap fund covers middle markets with a fee of 0.07%.
  • U.S. Large-Cap Growth ETF (NYSE:SCHG): Schwab’s large-cap growth ETF also has charges just 0.07%.
  • U.S. REIT ETF (NYSE:SCHH): This product offers exposure to REITs domiciled in the United States with a 0.07% fee.
  • U.S. Large-Cap Value ETF (NYSE:SCHV): This large-cap value ETF also has a fee of just 0.07%.

Given these low fees, is there any reason to go with the more expensive, active management style of mutual funds? For your core portfolio, which probably doesn’t change all that often, it’s hard to beat these low-cost ETFs.

However, I see two opportunities for the mutual fund industry.

The first is to offer funds that are more focused. Instead of funds with a hundred holdings or more, which almost guarantees that a fund’s performance will be right at a benchmark index, why not reduce holdings to around 25 to 30 so that stock picking has an impact?

The other opportunity is in specialty funds, where active management and especially risk management are vital. Whether its healthcare, defense stocks, frontier markets, microcaps, or Southeast Asian markets, investing on autopilot can be a disaster.

There’s a place for both ETFs and mutual funds in your portfolio, but think carefully about the choices and keep an eye on expenses.

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