Why Are ETF Fees Lower Than Mutual Fund Fees?

The fees charged to investors who buy into exchange-traded funds (ETFs) are typically lower than those charged for mutual funds. The gap is closing, though, as mutual fund providers respond to fierce competition from ETFs for investors' dollars.

• The average expense ratio for an index ETF was 0.16% in 2022, according to industry research.
• The average cost for an actively managed mutual fund was 0.66%. For passive mutual funds, it was 0.05%.

In all cases, those numbers represent a reduction in costs over the previous year. The average cost to investors of both mutual funds and ETFs has been cut in half over the past two decades.

Mutual Funds

The expense ratio is reported in every mutual fund prospectus and can be found in its listing on the company's website. It's an important number, but not the only important number.

The possible costs to investors of mutual funds break down into several categories. Not all funds will have all of these fees:

• Management fees, which compensate the people who make the buying and selling decisions for the fund.
• 12b-1 fees, which the company uses to pay marketing costs and, sometimes, employee bonuses. These cannot exceed 1% of the investor's assets.
• "Other expenses."
• Account fees, which may apply only to accounts that fall below a certain level.

All of the above fees are recurring charges that are deducted annually.

In addition, there may be fees attached to a number of actions that the investor initiates, such as buying or selling shares, or transferring them to a different fund.

The fee to purchase shares is the so-called "load fee" paid to the broker or agent who sells the shares. This is a one-time charge that is typically about 5% of the amount being invested. (The legal maximum is 8.5%.)

This particularly unpopular fee can be easily avoided, as thousands of "no-load" funds are available for purchase directly from the fund company or from any of its partner companies.

Active vs. Passively-Managed Funds

Actively managed mutual funds have higher fees than passive funds. Remember that the average expense ratio is 0.66% for actively managed funds compared to 0.05% for passive funds. And that is because they are managed very differently, and their objectives are different:

• An actively managed fund has a manager, or a team of them, devoted to buying and selling stock frequently. Their goal is to beat the performance of a particular benchmark index,
• A passively managed fund is set up to mimic a specific benchmark index. No investing decisions are made. The only buying and selling are done to mirror changes in the index. The stated goal, in this case, is usually to match the benchmark.

It is a matter of debate whether actively managed funds or passive funds actually perform better. It's not a simple question, given the enormous number of both that are on the market.

It is safe to say, however, that many passively-managed funds beat the returns of many actively managed funds, not least because of the higher costs of active management.

ETFs

Exchange-traded funds have costs, too, but the only way to examine them is to look at the fund's expense ratio. The fund management costs are not reflected in their statements. They are deducted daily from the net asset value of the fund.

Low Fees

Nonetheless, the administrative costs of managing ETFs are lower.

Most are passively managed funds, and they are always "no-load." That is, there is no set commission fee (it might cost $8 to $10 to invest in an ETF through a brokerage firm). Some online brokers charge zero for a limited number of ETF trades.

All of this adds up to lower costs for the investor.

No 12b-1 Fee

Unlike mutual funds, ETFs do not charge annual 12b-1 fees. These fees are advertising, marketing, and distribution costs that a mutual fund passes along to its shareholders. They cover the expenses incurred in marketing the fund to brokers and investors. In essence, each mutual fund shareholder pays for the fund company to acquire new shareholders.

Market-Based Trading

Another way ETFs keep their administrative and operational expenses down is through the use of market-based trading. Because ETFs are bought and sold on the open market like stocks or bonds, the sale of shares from one investor to another has no effect on the fund itself.

But when mutual fund shareholders sell shares, they redeem them from the fund directly. That often requires the fund to sell some assets to cover the redemption. When the fund sells off part of its portfolio, it generates a capital gains distribution to all shareholders.

The end results: mutual fund shareholders end up paying income taxes on those distributions, and the fund company spends time handling transactions, increasing its operating expenses.

Since the sale of ETF shares does not require the fund to liquidate its holdings, its expenses are lower.

In-Kind Creation and Redemption

Though once available only to large-scale institutional investors and brokerage firms, ETFs now use in-kind creation and redemption practices to keep costs down. Using this process, investors can trade a collection, or basket, of stock shares that match the fund's portfolio for an equivalent number of ETF shares.

In-kind redemption means that an investor can redeem shares by swapping them for an equivalent basket of stocks rather than selling the shares on the secondary market. The fund does not have to buy or sell securities to create or redeem shares, further reducing the paperwork and operational expenses incurred by the fund.