ETFs vs Mutual Funds (Part 1 of 3)

by Evan on November 6, 2009

Over the next several weeks, I will begin to explain the differences between exchange traded funds (ETFs) and mutual funds.  Today I want to focus on one of the major differences: cost or expense ratio (ER).  All mutual funds and ETFs charge a fee for a manager to over see the day to day operations of the fund.  These expenses typically include salary for the managers, sales/purchases of securities, marketing fees, sales loads/commissions paid to brokers, etc. 

A huge difference between ETFs and mutual funds is that there are no sales loads/commissions paid to brokers to distribute ETFs.  This fee is usually paid to a broker for selling a specific fund to a client.  In return the mutual fund company compensates the broker for the sale with a commission.  Another expense that mutual funds have that ETFs do not is called a 12-b1 fee, or a marketing fee.  This fee is charged to the client via a quarterly or yearly withdraw from the fund holdings.  While this fee is small, it still can add up with other expenses to create a large piece of the investment returns for the year.  Finally, some mutual funds charge a “short term trading fee”, which means that if you do not hold on to the fund for 90, 180, or even 365 days in some cases, the holder of the mutual fund is hit with a sales fee.  No ETFs charge this fee. 

In fact, the only fee that ETFs charge that mutual funds do not, most of the time, is a brokerage commission to buy or sell the ETF.  This fee is usually small ranging from free at some institutions to $20 at most discount brokerage companies.  So if you plan on buying small dollar amounts of funds over time, it might be beneficial to find a low-cost, no load (meaning no commission being paid to a broker), and purchase it regularly, but otherwise, ETFs trump mutual funds with their efficient fee structure.

Due to all of the fees listed above, ETFs, even when comparing similar mutual funds to a matching ETF have higher expenses most of the time, especially when in comparison to holding mutual funds over long term investment horizons (over several years).   Next week I will discuss the tax efficiency of ETFs vs. mutual funds.

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