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ETF vs. Mutual Fund: What’s the Real Cost of Ownership?

02/15/2019

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The ETF vs. mutual fund debate can be another confusing and frustrating chapter of financial planning, representing another fork in the road alongside active vs. passive strategies, brokerage vs. 401(k) or Roth vs. traditional IRAs.
Any decision has tradeoffs, so the best outcomes are likely to be achieved by thoughtful planners who educate themselves, honestly frame any decision in the context of their own goals and needs, and create robust plans that are not designed to fail under any circumstance.
ETFs vs mutual funds are functionally very similar, and both vehicles were designed to solve the same problems for individual investors.
However, there are some key differences, especially with regard to costs, which can have major ramifications for the successful implementation of either product in an investment plan.

ETF vs. Mutual Fund: Understanding the Difference in Structures

Variations in fund structure are an important factor that influences ownership costs in a number of ways.

Mutual funds are usually open-ended funds, a collective investment product that pools assets from a large number of shareholders. When new investors would like to become shareholders, they are issued new shares by the fund in exchange for cash, and that cash is then added to the pool of invested assets.

When shareholders would like to close their position, their shares are redeemed by the fund, with cash leaving the collective pool and going to the shareholder. These transactions take place after trading has ended for the day, and the price per share is equivalent to net asset value.

ETFs function more similarly to closed-end funds, in that only certain institutions engage in share issuance and redemption. Instead, transactions for shares typically occur on an open secondary market, with buyers and sellers interacting with each other through brokers or market makers. This means that share prices are dictated by supply and demand, rather than the values of the underlying assets.

The Easy Part: Analyzing the Headline Numbers

In the course of operating a fund, certain expenses are predictably incurred, and these are commonly measured with the expense ratio, which expresses annual operating costs as a percentage of total assets under management.

These operating costs can include the salaries of portfolio managers, research analysts and administrative staff, marketing expenses, and administrative costs.

Expense ratios are displayed in fund prospectuses and on information pages, and these fees are pulled directly from the fund asset pool, thereby reducing net asset value.

A Wide Range of Expense Ratios

Expense ratios vary widely among ETFs vs mutual funds, and these can be attributed primarily to variations in management style, fund type, and scale. A survey of data across the market indicates that passive index funds charge much lower fees than actively managed funds, and that average fees are falling, even when adjusting for the growth of passive strategies, due to increasing competition.

Index mutual funds carry an average expense ratio of roughly nine basis points, whereas actively managed funds are a much higher 59 basis points, though that number can nearly double for the most expensive funds.

Index equity ETFs have an asset-weighted average expense ratio around 20 basis points according to ICI, largely because ETFs have become a more common vehicle for targeting exposure to common and obscure indexes alike. Conversely, the popular equity index mutual funds tend to track the more well-known categories such as the S&P 500.

Expense Ratios of the Larger, More Popular Index Funds

Consider some of the largest, most well-known index funds across both investment structures. Vanguard’s S&P 500 ETF (VOO) carries a 0.04% expense ratio, compared to 0.09% for the SPDR S&P 500 ETF Trust (SPY) and 0.04% for the iShares Core S&P 500 ETF (IVV). The Vanguard 500 Index Fund Investor Shares (VFINX) carries a 0.14% expense ratio, as opposed to Fidelity 500

Index (FXAIX) at a much lower 0.015%.

Surveys of industry wide data and some anecdotal evidence above illustrates the overlap when comparing expense ratios of ETFs vs. mutual funds, but a common thread throughout is that passive strategies are cheaper than active management, regardless of fund structure. ETFs have emerged as an efficient tool in an era where passive investing is taking over, so they are more often than not designed to track an index.

Digging a Little Deeper into Taxation

Proper analysis of true cost requires a plunge into the less obvious erosion factors that are not captured in the expense ratio, and taxation is one of the most important differences between ETFs vs index mutual funds.

ETFs have an advantage in real cost when it comes to tax due to the different structures between the two products. Collective investment funds periodically sell portfolio assets, regardless of the strategy because of index reconstitution, simple rebalancing, or the closure of actively managed positions.

In all of these instances, securities that are sold above their cost basis are associated with a capital gain, and the fund must pay either short-term or long-term capital gains tax. These expenses are passed on to investors.

Taxes incurred at the fund level for ETFs are usually modest, especially for passive funds with low portfolio turnover. However, an otherwise identical index mutual fund has a disadvantage due to the process of issuing and redeeming shares. When holders return their shares to the fund in exchange for cash, the fund theoretically needs to sell securities from the asset pool to generate the cash payout.

When this happens at a large scale, it creates many taxable events that weigh on the returns for remaining shareholders. Actively managed funds tend to have more turnover, and therefore more tax drag, which is estimated at 2% for mutual funds of all varieties. It is safe to assume that tax drag is lower for index funds, but they still lose efficiency relative to comparable ETFs.

Digging a Little Deeper into Transaction Costs

It costs money to transact either mutual fund or ETF shares, though these costs can be somewhat different due to fund structure.

Mutual funds transactions can be subject to loads, marketing fees, brokerage commissions and fees charge by the fund itself. ETF trading can incur brokerage commissions, trade fees, and the erosive impact of the bid-ask spread, which instantly reduces the resale value of any market-based security the moment it is purchased.

The quantitative impact of these costs vary greatly, depending on the fund and method by which shares are purchased. However, mutual fund purchases are estimated to cost $30 in transaction fees, while ETFs cost $8.90 per trade on average without the help of a broker, or $30.99 with broker assistance.

Very low cost and high cost options exist for both mutual funds and ETFs, so it is hard to declare a clear winner, but ETFs that trade on platforms with zero or low trade commissions seem to hold a slight edge.

Remember that Turnover is Important to You

Turnover refers to the percentage of portfolio assets that are bought and sold each year, and this metric is not necessarily dependent on fund structure, but more so on strategy. Mutual funds are more popular vehicles for active management than ETFs, but high and low turnover versions of each exist.

Average turnover for ETFs falls in the 20 to 30% range, though popular large cap ETFs have turnover below 5%. Actively managed mutual funds average 85% portfolio turnover, though again there are many popular index funds below 5% turnover.

Turnover should be minimized when possible, because 100% portfolio turnover is estimated to add 120% of expenses annually. That is part of the drag that eliminates net alpha created by active mutual fund managers.

What is NAV Drift?

ETFs can calculate and publish net asset value (NAV), but the market price is ultimately the important factor for investor returns. ETFs can drift from NAV periodically, because their price is determined on the open market, though this drift usually signals some pricing inefficiency that is modest and quickly erased. Nonetheless, these short-term pricing inefficiencies can erode ETF value and constitute a real cost for anyone forced to unload shares at inopportune times.

Why You Need to Think About Your Other Assets

Ultimately, the interaction between ETFs vs mutual funds and the rest of your financial plan has meaningful consequences for true economic costs, like opportunity costs.

Mutual fund shares are a fairly liquid asset, but they lack the intra-day liquidity provided by cash products, individually held securities, or ETFs. This could have major ramifications for business owners or opportunistic investors who might need liquidity at a moment’s notice.

Similarly, ETF liquidity depends on trading volumes. While very few ETFs are so thinly traded that this presents a problem, there are some with low enough demand that it could be difficult to offload shares in any volume without incurring some decline in value.

Investors should also consider the function that the respective funds will play in their overall portfolio. ETFs can be excellent streamlined instruments, but sometimes, professional management can be extremely beneficial, especially for risk-averse investors. Pre-retirees or retirees might have limited room for error, thus justifying higher fees for bond funds or actively managed funds with downside protection.

DISCLOSURES

Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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