Low Fees

ETFs are more economical than mutual funds for most investment strategies. They are much cheaper than actively managed mutual funds and slightly cheaper than most comparable index mutual funds. The following table compares annual management fees, called expense ratios, between the least expensive ETFs and mutual funds for several categories of funds:

These differences may not seem huge, but over time they compound noticeably. Differences between ETF fees and actively managed funds' are typically 1% per year, which truly compounds dramatically.

ETFs are burdened by the fact that they are sold only through brokerage firms, which charge a trading fee once for buying and once for selling a security. This can range from a mere $7 for flat-rate electronic brokers to many times that amount for personalized, full-service brokers. The amount of transaction fees in and out can be divided by the amount of the purchase to determine the transaction fee as a percentage of assets. Ideally these transactions fees will be under 1%. There is no "load" or special sales charge with ETFs.

Traditional mutual funds may be purchased directly from the fund company, avoiding transaction fees. In practice many investors prefer to buy them through a brokerage firm out of convenience, which inevitably involves a sales charge as much or greater than the one incurred for buying ETFs. They may have loads or may be no-load.

Another consideration is tax effects, an advanced but important subject. In summary, ETFs do very well against traditional mutual funds, especially actively managed ones.

Finally there are a number of subtle differences in indirect costs which do not obviously favor either type of fund. Observers have pointed out that ETFs suffer also from the bid-ask spread, that is the difference in any stock between what sellers are asking and what buyers are bidding. That difference is picked up by all the middlemen in the market who enable the transaction. In the case of major ETFs, however, it is particularly small since they often trade in very high volumes. Some thinly traded ETFs may show high bid-ask spreads.

Traditional mutual funds have bid-ask spread costs of a different nature. Every time an investor brings more money into the fund, it must go out into the markets and obtain shares of all the companies in the index in question. Each of these stock purchase transactions contain bid-ask spreads. ETFs, in contrast, often assemble their basket of stocks by borrowing them for a fee from large institutional pension plans. All these indirect costs are real but it is not clear which fund is at an advantage.

One kind of investment not well-suited to ETFs is small dollar-cost average investing. This is the practice of setting aside and investing a modest amount each week or month. Because of minimum transaction fees by brokers for buying an ETF, at least $1,000 is the minimum practical amount needed per ETF purchase to keep transaction fees to a modest percentage of assets.

Mutual funds often require $1,000 or $2,000 initial investment, but after that they often do not object to small regular additions. Stick to traditional mutual funds if you must add to your account in amounts smaller than that.