How Do ETF Fees Work?

Many investors know that a primary benefit of ETFs is their low expenses. But what exactly is the cost, and how are ETF fees deducted? Understanding how fees work is an important aspect of investing success.  

Learn how ETF fees work, why they’re generally lower than those of mutual funds and why low fees matter. 

What Are ETF Fees? 

ETF fees are expenses passed on to the investor from the managing fund company. Like any typical business entity, an ETF company may incur a range of operational expenses, including management fees and marketing costs. These costs are passed on to the shareholders of the ETF and are expressed as a percentage called an expense ratio.  

An ETF expense ratio tells an investor how much they’ll pay over the course of a year to own the fund. For example, if an ETF expense ratio is 0.20%, the investor’s cost to hold the fund for a year is $20 for every $10,000 invested. 

How Are ETF Fees Deducted? 

ETF fees are operational expenses that are deducted from the fund assets. Therefore, investors do not pay fees directly to a fund manager. Since ETFs are traded on an exchange like stocks, they may also be subject to brokerage fees, which are commissions that are typically not more than $20 per trade. 

ETF fees are accrued daily, which means they are reflected in the daily price of an ETF; however, the fees are typically deducted from fund assets on a monthly basis.  

From the investor’s perspective, ETF fees are not directly paid like a monthly bill. Instead, they are reflected in a fund’s net return. For example, if an ETF expense ratio is 0.10%, and the total return before fees is 9.00%, the net return to the investor is 8.90%. Thus, an ETF’s return is the total return of the fund portfolio, less expenses. 

Why Do ETF Fees Matter? 

Since many ETFs passively track a benchmark index, the fees charged by the ETF will have a direct impact on how closely the fund tracks the performance of the index. All other things being equal, the ETF with the lowest fees will have higher returns over time. 

Why Are Fees Lower for ETFs vs Mutual Funds? 

When comparing ETFs versus mutual funds, the primary reason ETFs are so cheap is that they are passively managed, and they trade seamlessly on an exchange. For example, equity ETFs average 0.16% in expense ratios, whereas stock mutual funds average 0.47%. 

The longer answer for why ETFs are generally cheaper than mutual funds involves the unique creation and redemption process of ETFs.  

ETFs are made up of creation units, whereas mutual funds are portfolios made up of investment security holdings. For example, if an ETF is designed to track the S&P 500 index, the ETF’s “authorized participant” will buy shares in all the S&P 500 constituents in the exact same weights as the index, then deliver those shares to the ETF provider. In exchange, the provider gives the AP a block of equally valued ETF shares, called a creation unit.  

The exchange takes place on a one-for-one, fair-value basis. The AP delivers a certain amount of underlying securities and receives the exact same value in ETF shares, priced based on their net asset value (NAV), not the market value at which the ETF happens to be trading. This whole process enables ETFs to trade like stocks on an exchange, which means investors can buy and sell shares of ETFs with each other in the secondary market, rather than using an intermediary like a mutual fund to buy and sell securities in a portfolio. 

Put simply, when investors want to buy shares in an ETF, they enter an order with their brokerage and that’s it. But when investors add new money to a mutual fund, the fund company must take that money and go into the market to buy securities. ETFs are cheaper than mutual funds because they trade seamlessly on an exchange, whereas mutual funds involve third-party interaction that adds to the cost of management. Less work equals lower cost for ETFs. 

Bottom Line 

ETF fees are operational costs of the fund that are passed along to ETF shareholders. These fees are deducted from the fund assets and are therefore not directly paid by investors. The primary reason ETF expenses are generally lower than mutual funds is that they passively track a benchmark index and seamlessly trade on an exchange like stocks.