With all things being equal—the structural differences between the 2 products give ETFs a cost advantage over mutual funds.
WILEY GLOBAL FINANCE
For the most part, ETFs are less costly than mutual funds. There are exceptions—and investors should always examine the relative costs of ETFs and mutual funds. However—all else being equal—the structural differences between the 2 products do give ETFs a cost advantage over mutual funds.
Mutual funds charge a combination of transparent and not-so-transparent costs that add up. It's simply the way they are structured. Most, but not all, of these costs are necessary to the process. Most could be a little cheaper; some could be a lot cheaper. But it's nearly impossible to get rid of them altogether. ETFs have transparent and hidden fees as well—there are simply fewer of them, and they cost less.
Mutual funds charge their shareholders for everything that goes on inside the fund, such as transaction fees, distribution charges, and transfer-agent costs. In addition, they pass along their capital gains tax bill on an annual basis. These costs decrease the shareholder's after-tax return on their investment. On top of that, many funds charge a sales load for allowing you the pleasure of investing with them. On the other hand, ETFs offer more trading flexibility, generally provide more transparency, and are more tax efficient than mutual funds.
Load
Most actively managed funds are sold with a load. Loads for mutual funds generally range from 1% to 2%. Most of these funds are sold through brokers. The load pays the broker for their efforts and gives an incentive to suggest a particular fund for your portfolio.
Financial advisors get paid one of 2 ways for their professional expertise: by commission or by an annual percentage of your entire portfolio, usually between 0.5% and 2%, in the same way you pay an annual percentage of your fund assets to the fund manager. If you don't pay an annual fee, the load is the commission the financial advisor receives.
ETFs don't often have large fees that are associated with some mutual funds. But because ETFs are traded like stocks, you may pay a commission to buy and sell them, although there are commission-free ETFs in the market.
To be fair, mutual funds do offer a low cost alternative: the no-load fund. True to its name, the no-load fund has no load. Every single dollar of the $10,000 that you want to invest goes into the index fund; none of it is whisked away by a middleman. The reason for this is that you do all the work that the stockbroker does for the average investor. You do the research and you fill out the forms to purchase the fund. In essence you are paying yourself the broker's commission, which you invest.
Most index funds and a small group of actively managed funds don't charge a load. No-load index funds are the most cost efficient mutual funds to buy because they have smaller operating costs.
Expense ratio
In a mutual fund's prospectus, after the load disclosure is a section called "Annual Fund Operating Expenses." This is better known as the expense ratio. It's the percentage of assets paid to run the fund. Well, most of them. Many costs are included in the expense ratio, but typically only 3 are broken out: the management fee, the 12b-1 distribution fee, and other expenses.
In addition to paying the portfolio manager's salary, the management fee covers the cost of the investment manager's staff, research, technical equipment, computers, and travel expenses to send analysts to meet corporate management. While fees vary, the average equity mutual fund management fee is about 1.10%.
Mutual funds and ETFs can be either actively or passively managed. Active management can be a good thing if the fund manager is talented and is able to outperform the market.
12b-1 fees
Some mutual funds—including many no-load and index funds—charge investors a special, annual marketing fee called a 12b-1 fee, named after a section of the 1940 Investment Company Act. The 12b-1 fee is broken out in the prospectus as part of the expense ratio. It can run as high as 0.25% in a front-end load fund and as high as 1% in a back-end load fund. Many investor-right advocates consider these expenses to be a disguised broker's commission.
One thing can be said for the front-end and back-end loads: They're upfront about what the fee will be, and it's a one-time charge. Essentially, you go to a broker, they help you to buy a mutual fund, and you pay for the service.
This is not the case with the 12b-1 fee. While it is intended to pay for promotion and advertising, only 2% of the fees are used for that. The rest is paid to brokers for ongoing account servicing. Essentially, it's paid to the broker who sold you the fund on an annual basis, for as long as you own the fund, even if you never see the broker again.
ETF costs
In contrast to mutual funds, ETFs do not charge a load. ETFs are traded directly on an exchange and may be subject to brokerage commissions, which can vary depending on the firm. While the absence of a load fee is advantageous, investors should beware of brokerage fees, which can become a significant issue if an investor deposits small amounts of capital on a regular basis into an ETF. In many cases, an investor interested in pursuing a "dollar cost averaging strategy" or a similar strategy that involves frequent transactions, may want to explore closely alternatives offered by mutual fund companies to minimize overall costs.
ETFs expense ratios generally are lower than mutual funds, particularly when compared to actively managed mutual funds that invest a good deal in research to find the best investments. And ETFs do not have 12b-1 fees. That said, according to Morningstar, the average index ETF expense ratio in 2023 was 0.48% and 0.73% for active ETFs, compared with the average expense ratio of 0.81% for index mutual funds and 1.02% for actively managed mutual funds.
