Watch Out for These Costly Investments

Exchange-traded funds give investors a great way to invest in the widest possible array of investments available. But as with any other investment, you have to be careful not to pay too much for the privilege of owning ETF shares. Unfortunately, the annual expenses of some ETFs make it a lot harder to earn the profits you need in order to reach your financial goals. That raises a key question: Are high-cost ETFs ever justified?

The conundrum of ETF costs
Mutual fund investors have long understood the impact of fees and costs on their total return. It's as simple as this: Every dollar that goes to pay a fund manager or reimburse the costs a fund incurs is a dollar that doesn't come back to you when you cash in your shares. In a major bull market, it's easy to overlook the downward-pulling effect of those costs, but when good returns are hard to come by -- as they have been for quite a while now -- it's much clearer that you can't afford to waste any of your hard-earned investment gains.

What makes high fees for ETFs even more egregious is that unlike mutual funds, most ETFs passively follow indexes rather than making active investment decisions. With mutual funds, you can at least feel like your money is going to pay investment professionals to make smart decisions about which stocks are likely to outperform their peers. But with index ETFs, it's not always clear how you're getting your money's worth -- or even what you're paying for.

For instance, here's a list of the five most expensive ETFs, according to Morningstar:

Source: Morningstar.

At least from this list, you can see that investors are hungry for ETFs that will take a stand in their respective sectors. For instance, the Active Bear ETF seems tailor-made for the current market environment, with short positions in stocks such as Ebix (NAS: EBIX) and Whirlpool (NYS: WHR) that have seen their stocks drop dramatically this year. A past mistake with Green Mountain Coffee Roasters (NAS: GMCR) held back the ETF's performance earlier this year, but the ETF had a stellar third quarter.

Similarly, Dent Tactical takes an active view of investing. But with a current allocation of just 16% to inflation-protected bond ETF iShares Barclays TIPS (NYS: TIP) and 17% in PowerShares US Dollar Index Bull and the rest of the fund in cash, investors have to wonder whether paying 1.5% annually for the privilege is worth whatever timing benefits they may get. The same general idea holds for other tactical ETFs; given the transparency of ETFs, any proprietary advantage the fund has doesn't last very long.

With Peritus High Yield, however, investors get what amounts to full active management in an asset class that's hard to replicate on your own. Although passive junk bond ETFs exist, they track indexes that include a lot of bonds that smart investors avoid. Sure, it's tough to overcome an extra percentage point of expenses, but if Peritus can manage to steer clear of a default that the junk bond indexes fall into, then it can quickly pay for itself.

Do it yourself and save
I'm skeptical that any ETF is worth a 3% fee. If you want the short exposure that Active Bear gives you, then you can simply look up a list of its holdings and short the stocks yourself, or short a low-cost index ETF like Vanguard Total Stock Market (NYS: VTI) for a broad-based bearish bet.

Unless an ETF gives you exposure to an asset class that's hard to add to your portfolio on your own, there's little reason to pay through the nose for it. Sticking with low-cost ETFs may not be as exciting as a more active strategy, but over the long haul, you're likely to get much better results with them.

If you'd like to see some lower-cost fund choices, check out the Motley Fool's free special report on ETFs. We've found three ETFs you should know about.

At the time thisarticle was published Fool contributor Dan Caplinger cuts costs wherever he can. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Peritus High Yield ETF and Ebix. Motley Fool newsletter services have recommended buying shares of Green Mountain Coffee Roasters and Ebix, as well as creating a lurking gator position in Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't cost you an arm or a leg.

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