An Unfair Race: Why Exchange-Traded Funds are Cheaper - dummies

An Unfair Race: Why Exchange-Traded Funds are Cheaper

By Russell Wild

The management companies that manage exchange-traded funds (ETFs), such as BlackRock, Inc. and Invesco PowerShares, are presumably not doing so for their health. No, they’re making a good profit. One reason they can offer ETFs so cheaply compared to mutual funds is that their expenses are much less.

When you buy an ETF, you go through a brokerage house, not BlackRock or Invesco PowerShares. That brokerage house (Merrill Lynch, Fidelity, TD Ameritrade) does all the necessary paperwork and bookkeeping on the purchase.

If you have any questions about your money, you’ll likely call Schwab, not BlackRock. So unlike a mutual fund company, which must maintain telephone operators, bookkeepers, and a mailroom, the providers of ETFs can operate almost entirely in cyberspace.

ETFs that are linked to indexes do have to pay some kind of fee to Dow Jones or MSCI or whoever created the index. But that fee is nothing compared to the exorbitant salaries that mutual funds pay their stock pickers, er, market analysts.

Active mutual funds really don’t have much chance of beating passive index funds — whether mutual funds or ETFs — over the long run, at least not as a group. (There are individual exceptions, but it’s virtually impossible to identify them before the fact.)

Someone once described the contest as a race in which the active mutual funds are “running with lead boots.” Why? In addition to the management fees that eat up much of any gains, there are also the trading costs.

Yes, when mutual funds trade stocks or bonds, they pay a spread and a small cut to the stock exchange. That cost is passed on to you, and it’s on top of the annual management fees previously discussed.

It’s been estimated that annual turnover costs for active mutual funds typically run about 0.8 percent. And active mutual fund managers must constantly keep some cash on hand for all those trades. Having cash on hand costs money, too: The opportunity cost is estimated to be in the neighborhood of 0.4 percent.

So you take the 1.33 percent average management fee, and the 0.8 percent hidden trading costs, and the 0.4 percent opportunity cost, and you can see where the lead boots come in. Add taxes to the equation, and while some actively managed mutual funds may do better than ETFs for a few years, over the long haul many of them are unlikely to come out out ahead.