ETFs Made Easy: Why Are ETFs Cheap?

January 13, 2015

In this series, we answer the questions investors are afraid to ask. You can submit your questions to me at [email protected]. All correspondence will remain anonymous.

 

One of the most common claims made about ETFs is that they’re cheaper than mutual funds. It’s taken as such a given that I’ve received several emails in the past few weeks asking a really simple question:

 

“Are ETFs always cheaper? And if so, why?”

 

The answer to this question isn’t clear cut. Many of the cheapest investment products in the world are U.S.-listed ETFs. In fact, for the iShares Treasury Floating Rate Bond ETF (TFLO | 100), currently all fees and expenses are covered by a waiver, making it free.

 

Less gimmicky, two core Schwab offerings—the Schwab U.S. Broad Market ETF (SCHB | A-100) and the Schwab U.S. Large Cap ETF (SCHX | A-95)—currently carry, god-as-my-witness, expense ratios of just 4 basis points.

 

In fact, the broad market fund is 5 basis points cheaper than Schwab’s own Total Stock Market Index Fund (SWTSX).

 

Of course, not all ETFs are so stingy. Some 152 ETFs have all-in expenses of more than 1 percent, usually for accessing highly specialized investment strategies like commodities, MLPs, business development companies or using leverage.

 

Still, the average mutual fund is in fact more expensive than the average ETF, and for some highly predictable reasons. Let’s look at what goes into a typical mutual fund expense ratio …

 

Management Fee

For most ETFs and mutual funds, the fee paid to the investment advisor to actually run the fund is going to be the single-largest expense. In ETFs, it’s extremely common for a fund issuer to simply say, “we’ll cover ALL of the expenses of running the fund; just pay us the management fee.”

 

That’s what the two Schwab funds do, making their prospectus extremely clean:

 

 

Because most ETFs are indexed—rather than run by a team of active managers—it actually costs less to do this job, and that cost is generally passed on to you as an investor. That lower cost to run the fund, however, is true regardless of whether the fund is exchange-traded, which is why there are some very, very cheap index mutual funds out there.

 

Administrative Expenses

The second line item in most prospectuses will just be rolled up as the unhelpful “Other Expenses” line, which, as I said, will often be zero, as the fund manager covers the expenses.

 

One company that doesn’t is Vanguard—part of its ethos of just running things as low cost as possible and passing on the savings is accurately reflecting those costs. So a fund like the Vanguard MegaCap (MGK | A-95) shows this in its prospectus:

 

 

What’s in those “other expenses?” Well, there are basic functions, like fund accounting, paying the board of trustees’ expenses, paying lawyers, fees to custodians for holding the assets, and the like. In the case of MGK, all those fees added up to just 3 basis points.

 

How does that stack up against mutual funds? Generally pretty favorably. Here’s the prospectus line for one of the largest equity mutual funds in the world, Growth Fund of America:

 

 

 

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