One perceived advantage of exchange traded funds (ETFs) over open-end mutual funds is their greater trading flexibility.
Many investors believe that there are also advantages in respect of ETF costs. Specifically, expense ratios, transaction costs, and tax efficiency. As with trading flexibility, the potential advantages will vary between investors depending on their investing tactics. I will lay out the reality and you can decide if there is a benefit for you.
We will cover annual expense ratios below, with transaction costs and tax efficiency next week.
ETFs tend to have lower expense ratios than open-end index mutual funds that track the same benchmarks.
That is a fact.
But, like most things, there is a little more to it than that.
Expenses Can Differ Between Funds
The difference between index fund expenses can vary to some degree. And when you include actively managed funds in a specific category, the differences can be substantial.
Consider the Standard & Poor’s (S&P) 500 index. The S&P 500 is considered a Large-Cap Blend investment style.
Per Morningstar data as at September 4, 2018, the average expense ratio for funds in this category, which includes both actively managed and index funds, is 0.99%. That is a lot of return paid back to the fund each and every year.
Being an average calculation, we will find both higher and lower expense ratios in this category.
For example, the no load Fidelity® Total Market Index F (FFSMX) has an annual expense ratio of 0.02%. On the other side, the no load American Century Core Equity Plus R (ACPWX) has an expense ratio of 2.35%. Quite the range!
One would hope that the higher cost funds outperform the lower cost ones. But that is not often the case. In the example above, over the last 5 years the Fidelity fund achieved an annual return of 14.22%. The higher cost American Century only averaged 11.38% per annum. And that is not cherry picking data.
Higher cost does not usually translate into better results. In fact, annual expense ratios are usually a drag on net returns. That is, higher cost funds do not outperform. Investing in low cost products tends to be the better route.
ETF Expenses Should Be Lower
Now if we compare these specific funds to certain S&P 500 ETFs, we see even lower costs with the ETFs.
That said, over the last few years, mutual funds have really tightened the costs on their index funds. Primarily in response to investor cash flowing out of mutual funds and into the less expensive ETFs. We saw that in out example above with Fidelity. As well, behemoths like Vanguard and iShares also offer very low cost mutual funds.
You will also find higher cost ETFs as their fund companies branch into actively managed ETFs. As well, more niche asset classes that cost more to administer.
But, if we consider plain-vanilla S&P 500 index ETFs, on average they will be less costly than mutual funds. For example, Vanguard S&P 500 ETF (VOO) and iShares Core S&P 500 ETF (IVV) each charge only 0.04% per annum.
Keys to Remember
From this, I suggest you take away five points.
One, there is a significant variation in expense ratios between open-end mutual funds in any given investment category. This is true for both actively managed funds and index funds. Make sure you do some comparison shopping before investing. Giving up 1.0% or more in return due to expenses is not a prudent way to accumulate wealth.
Two, there is some variation between the expense ratios of even the lower cost open-end index mutual funds. It may not be substantial, but still compare between index mutual funds.
Three, while ETFs currently have lower expenses than index funds, the gap has narrowed greatly in recent years. Do not automatically assume that you will save more money with an ETF over an open-end index fund. Depending on your investment tactics, you may not.
Four, expense ratios may vary between ETFs. While a top ETF should have lower costs than a top mutual fund, not every ETF may beat every index fund on cost. Make certain you choose wisely when selecting ETFs.
Five, cost minimization is crucial. But do not confuse that with getting value for your money. While an ETF may have the lowest expense ratios, there may be other factors that make open-end index funds preferable for your needs. Transaction costs are one such factor. We will review these, plus tax efficiency, next post.
