ETFs have found their way into countless portfolios over the years thanks to the efficiency of the exchange-traded product structure; day traders have embraced these funds for their unparalleled liquidity and precision, while investors have taken advantage of the low-cost and diversification features. While there’s more than a handful of reasons why ETFs are better than mutual funds, at the heart of the matter lies one straightforward advantage: cost [see The Cheapest ETF for Every Investment Objective].
There are many good reasons why a lot of noise has been made about the cost difference between mutual funds and ETFs. At ETF Database, we’ve certainly emphasized the cost advantage of ETFs over mutual funds, especially over a long-term investment horizon, and we’re certainly not alone when it comes to preaching the benefits of lower fund management fees. Many people must initially wonder why ETFs are cheaper than mutual funds.
Why Are ETFs Cheaper than Mutual Funds?
As you may have suspected, there isn’t one single reason in particular that explains this cost advantage; instead, it’s a number of factors that contribute to the sometimes extreme difference in fees between these two similar investment vehicles. As such, below we highlight three of the biggest reasons that explain why ETFs on average boast a much cheaper price tag than comparable mutual funds [see also 7 Charts to Put the ETF Industry in Perspective ].
It’s Cheap to Run a Passive Fund
Operational expenses play a big role when you consider the total cost of running an actively-managed mutual fund; you need to staff research personnel, equity analysts, and accountants, just to name a few of the necessary costs that mutual fund companies must absorb, and eventually pass off to investors. Plain and simple, it’s much cheaper to run a passive, index-based ETF. This way there is no need for analysts because the fund simply tracks a benchmark and the accounting burden is also passed off to the brokerage firm.
The fees on actively-managed ETFs more closely resemble those of active mutual funds, but seeing as how there are less than 100 active ETFs in a universe now totaling 1,600 products, it’s safe to say that investors are most likely to stumble upon the cheaper, index-based exchange-traded funds.
No Administrative Burden
The one word that best describes the difference between what goes on behind the scenes when you buy or sell an ETF compared to a mutual fund is: less. That is to say, there are fewer intermediaries, fewer trading costs, and fewer administrative requirements that must take place when you trade ETFs, which ultimately leads to lower fees for investors. Because ETFs trade on an exchange intraday like a stock would, the ETF issuer does not need to be involved in every transaction that investors make; instead, the issuer only plays a role when new shares must be created or redeemed [see ETFdb Cheapskate Portfolio].
Think of it like this: Apple (AAPL) has no involvement when investors are trading its shares, and in the same way, ETF issuers aren’t directly involved when investors trade their shares.
Forget 12b-1 Fees
What are 12b-1 fees? This is the annual marketing expense that many mutual fund companies incur, and ultimately pass off to investors.
What does this marketing expense cover and why should I pay for it? The 12b-1 fee is considered an operational expense that is intended to pay for marketing that should be increasing the assets under management in an effort to achieve economies of scale that should lower the fund’s expense fee over time. In reality, however, the majority of this fee is paid out as commissions to financial advisors for recommending the company’s funds to clients. Now as far as the second part of the question is concerned, we certainly don’t have a good answer.
Plain and simple, another big reason why ETFs are cheaper than mutual funds is because they do not charge 12b-1 fees; fewer operational expenses translates into a lower expense ratio for investors.
The Bottom Line
There are a number of reasons that contribute to the meaningful difference in costs between owning an ETF versus a mutual fund. At the root of this matter is the differences in product structure; ETFs are inherently more cost-efficient because they trade on exchanges just like a stock, which eliminates many of the operational fees that are otherwise associated with running a mutual fund. Furthermore, because most ETFs are passive, and linked to an index, the issuers themselves have fewer costs to pass onto investors, which ultimately leads to lower expense ratios.
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Disclosure: No positions at time of writing.