Why Are ETF Fees Lower Than Mutual Fund Fees?

ETFs vs. Mutual Funds

ETFs and mutual funds are both designed to capture investment gains, but they go about it in different ways. They both allow investors to buy smaller shares of a variety of assets, so instead of buying individual stock shares, you're buying into a pool of securities. Assets can include stocks, bonds, real estate investment trusts (REITs) and more, and you can add them to your portfolio with a single purchase. This allows for greater diversification and helps mitigate overall investment risk.

However, mutual funds and ETFs are not managed or traded in the same way. They also carry different costs and tax implications, which are important to understand as they can impact your returns over time.

Mutual Funds

A portfolio manager is often at the helm of a mutual fund. The manager makes investment choices on behalf of the fund in hopes of outpacing the market at large. But having a portfolio manager who actively trades securities in a fund typically triggers greater fees. Also, mutual funds not held in a tax-advantaged investment account such as a retirement account could expose you to annual capital gains tax. It's an important detail since mutual funds are often seen as long-term investment vehicles. They're designed to be held throughout seasons of market volatility, but this could result in a yearly tax bill.

ETFs

Instead of using a portfolio manager, most ETFs are passively managed, which means securities are traded only as needed. As a result, fees tend to be lower. ETFs trade like stocks, and shares can be bought and sold continually throughout the trading day (not so for mutual funds). Prices also fluctuate with supply and demand.

An ETFs' structure can be appealing to those who like a more hands-on approach to investing. Like index mutual funds, many ETFs are built to match the performance of a specific market index, such as the S&P 500 or Dow Jones Industrial Average. Where taxes are concerned, ETF owners usually sidestep capital gains tax until it comes time to sell their shares. All in all, ETFs allow for greater flexibility and frequent trading.

How Mutual Fund Fees Work

On top of any annual capital gains taxes you may owe on a mutual fund, their fees usually outweigh ETF costs. Mutual fund costs include:

• Load fees: Most actively managed funds tack on a "load" charge whenever shares are purchased. It goes toward the intermediary who facilitated the sale. Stockbrokers typically receive a 1% to 2% cut, according to Fidelity Investments. Financial advisors may take a flat commission or receive an annual percentage of your portfolio, usually to the tune of 0.5% to 2%.
• Operating expense ratio: This tends to be higher when compared with ETFs because the expense ratio also compensates the fund manager and their staff. It may also go toward administrative costs, technical support and other operating expenses. The average expense ratio for mutual funds is 0.74%. While expense ratios can vary, they cannot exceed 2%.
• 12b-1 fees: You may find this annual fee in a mutual fund's operating expense ratio. It's designed to cover the marketing and selling of fund shares, and it can also be used to pay for shareholder services. Total costs here are capped at 1% of your fund assets.
• Initial entry costs: Buying into a mutual fund can be pricey, typically ranging anywhere from $500 to $3,000.

How ETF Fees Work

Fees are generally lower for passively managed funds, and most ETFs are passively managed. It's always wise to compare costs before going all in, but below are some common fees you may encounter.

• Operating expense ratio: This represents the percentage of fund assets that is earmarked for operating expenses and administrative costs. ETF management fees, which compensate your brokerage for managing the fund, are typically baked into this ratio. It's an important metric because the operating expense ratio is a recurring fee that can eat into your returns over time. The asset-weighted average expense ratio for all U.S. ETFs and open-end mutual funds was 0.45% in 2019, according to investment research company Morningstar. In other words, the average ETF owner paid $45 for every $1,000 invested.
• Trade commission: Many brokerages offer commission-free trades, but some may charge flat fees as high as $25 per trade. The more you trade, the more you'll pay.
• Bid-ask spreads: The bid price is the highest amount an investor is willing to pay for an ETF. The ask price, on the other hand, is the lowest price the seller will accept. The difference is known as the bid-ask spread. Wider spreads generally translate to higher trading costs, and vice versa.
• Initial entry costs: Initial buy-in is on the lower end when compared with mutual funds. Investors can simply buy and sell ETF shares at the posted market price.

Fees go hand in hand with investment funds. On the whole, ETFs tend to be more cost-efficient than actively managed mutual funds. But with mutual funds, investors are essentially paying for a strategic fund manager who's looking to outperform the market. Depending on your investment style, that may be a worthwhile trade-off.

How to Lower Investment Costs

Investment costs can be unavoidable, but they don't have to be so big that they have a negative impact on your returns. Here are four ways to lower the cost of investing.

1. Choose a broker that doesn't charge commission. Many major online brokerages such as TD Ameritrade and Charles Schwab offer commission-free online trading, which means they don't charge their own fee when executing a trade. Keep in mind that there still may be other fees involved.
2. Look for no-load mutual funds. Some mutual funds are sold without load fees because the shares are distributed directly by the investment company instead of going through an intermediary such as a broker or financial planner.
3. Consider a robo-advisor. A robo-advisor is an automated digital platform that helps you make investments with little, if any, human interaction. Some providers charge varying fees, but others may be free.
4. Invest in an index mutual fund. You might also reduce your out-of-pocket costs by going with an index mutual fund. They're passively managed and mirror a market index, such as the S&P 500. Management fees are on the lower side, though returns are more likely to match the market than outpace it. An index mutual fund might even prove more affordable than an ETF. Just bear in mind that the initial investment may still be substantial.