The Cost Advantage of ETFs Compared to Mutual Funds - dummies

The Cost Advantage of ETFs Compared to Mutual Funds

Exchange Traded Funds (ETFs) offer a major cost advantage over mutual funds. The management companies that bring us ETFs, such as Barclays and PowerShares, can offer ETFs so cheaply compared to mutual funds because their expenses are much less.

For example, when you buy an ETF, you go through a brokerage house, not Barclays or PowerShares. That brokerage house (Charles Schwab, 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 Barclays. 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.

Active mutual funds really don’t have much chance of beating passive index funds — whether mutual funds or ETFs — over the long run. 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, just like you do.

It’s been estimated that 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: There’s an opportunity cost, estimated to be in the ballpark of 0.4 percent.

So you take the 1.67 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 you shouldn’t bank on many of them coming out ahead.