Why Are ETF Fees Lower Than Mutual Funds?

There are a number of reasons why the fees associated with investing in exchange-traded funds (ETFs) are typically lower than for mutual funds. In addition to their efficient trading and redemption processes and passive management, ETFs do not carry 12b-1 fees or load fees. Though they carry operational fees, like mutual funds, and commission charges, ETFs tend to have lower total expenses than comparable investment products.

One of the biggest fees associated with mutual funds is the load fee, which is typically between 3 and 8.5%. Many mutual funds highlight the fact that they do not charge a commission for trades. However, load fees essentially accomplish the same thing by charging a shareholder a percentage of her total investment to compensate the broker who sold her the investment. Load fees can be front-end or back-end; they are paid at the time of purchase or redemption, respectively.

ETFs do not charge load fees. Instead, investors pay broker commissions when they buy and sell shares. Like trading stocks, these fees are fixed at certain dollar amounts, usually around $8 to $10. If you trade ETFs frequently, the commissions can add up. If you purchase a large stake and hold onto it, however, ETF investments are much cheaper than mutual funds. Investing $10,000 in a mutual fund may require up to $850 in load fees, depending on the fund. Investing that same amount in an ETF, if done all at once, is infinitely cheaper.

Unlike mutual funds, ETFs do not charge annual 12b-1 fees. Despite the technical name, these fees are simply advertising, marketing and distribution fees that a mutual fund passes along to its shareholders. These fees cover the expenses incurred by marketing the fund to brokers and investors. In essence, each existing shareholder pays for the mutual fund to acquire new shareholders by footing a portion of its advertising bill each year.

Though it is not universally true, most ETFs are designed to be passively managed. The majority of ETFs on the market simply track a given index and seek to mimic or exceed the returns generated by the index. Rebalancing of assets, therefore, only takes place when the underlying index adds or removes a given security.

An ETF that tracks the S&P 500, for example, includes any stock listed on that index. Even if the stock begins to lose value, the fund does not sell unless the stock is removed from the index. This management style vastly reduces the number of trades an ETF executes each year, so its operating expenses are extremely low.

Though passively managed mutual funds, such as index funds, typically also have much lower expense ratios than their actively managed counterparts, the extra fees associated with mutual funds make ETFs the cheaper choice.

Another way ETFs keep their administrative and operational expenses down is through the use of market-based trading. Because ETFs can be bought and sold on the open market like stocks or bonds, the sale of shares from one investor to another has no effect on the fund itself. Conversely, when a mutual fund shareholder wants to sell her shares, she must redeem them with the fund directly, which often requires the fund sell some assets to cover the redemption. When the fund sells off part of its portfolio, it generates a capital gains distribution to all shareholders. Not only does this mean mutual fund shareholders end up paying income taxes on those distributions, but it also requires a lot of work and documentation on the part of the fund, increasing its operating expenses. Since the sale of ETF shares does not require the fund to liquidate its holdings, its expenses are lower.

Though typically only available to large-scale institutional investors and brokerage firms, in-kind creation and redemption practices used by ETFs also keep costs down. Using this process, investors can trade a collection, or basket, of stock shares that match the fund's portfolio for an equivalent number of ETF shares. In-kind redemption simply means an investor who wants to redeem shares with the fund, rather than selling on the secondary market, can be paid with an equivalent basket of stocks. The fund does not have to buy or sell securities to create or redeem shares, further reducing the paperwork and operational expenses incurred by the fund.