ETFs Made Easy: Why Are ETFs Cheap?

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:

A bit overwhelming, eh? Growth Fund of America, like many traditional active funds, comes in more than a dozen flavors—different share classes differentiated primarily by how they’re sold.

Note that, in every case, the management fee is a surprisingly cheap 28 basis points, and a lot cheaper than it was when it was launched decades ago. Notice that the “other expense” line is all over the place—different classes of the fund have different levels of assets.

Those 529 classes—which exist to be used in 529 education plans—have additional accounting and recordkeeping expenses that are paid by that class’ shareholders. All those “R” series represent different levels of expenses used to offset recordkeeping fees for 401(k) plans, and those fees are borne only by those investors.

What does all this have to do with ETFs? Well, from the perspective of the issuer, the ETF is the simplest of all structures to manage. Because they are exchange-traded, the issuer doesn’t even need to know who you are. It can rely on the brokerage community to distribute any documentation, just like how your broker sends you proxy statements from your stock holdings.

It doesn’t need to staff a phone bank, and if the funds are simple and index-based, even legal and accounting costs can be held to a very low level. And if they’re index based, even their internal custodial costs can be lower: fewer transactions = lower costs.

12b1 Fees: Marketing And Distribution

One thing you might notice from the Growth Fund of America table is all of those distribution fees—“12b1” fees for the part of the 1940 Act that allows them. Those are fees charged by a fund specifically to sell, market and otherwise distribute shares of the fund.

In the old mutual fund world, ETFs were often sold with a front-end commission or “load.” You’d give your broker $10,000, but only, say $9,500 would end up going to work. Those front-end loads paid for the supposed advice you were getting from your broker.

As investors balked at such front-end loads, the industry came up with all sorts of ways of trying to convince you to pay for that broker—level loads that you paid all the time, back-end loads that you paid if you sold, and so on. 12b1 fees vary based on which one of these archaic mechanisms you might be part of.

So-called no-load ETFs have 12b1 fees generally of 0.25 percent or less. And even without a broker or advisor in the mix, many traditional funds still collect that 24 bps and use it to offset the fees to be on mutual fund marketplaces like Schwab’s OneSource, or to be present in different 401(k) platforms, or even just to support marketing expenses.

While the vast, vast majority of ETFs do not charge any kind of 12b1 fee, it’s not the case that no ETFs use 12b1 fees. The very popular Select Sector SPDR ETFs, for instance, all have a very small 12b1 fee (just 0.04 percent) used to offset distribution fees.

The Bottom Line

The bottom line is the bottom line; that is, what matters to you as an investor is your total out-of-pocket expenses, not how they might be classified in the prospectus.

Many ETFs are in fact much cheaper than their traditional mutual fund counterparts, for good reasons: index-based strategies, and built in administrative cost advantages.

But you should never assume that “ETF” always means “cheap,” and you should always read the prospectus to make sure you understand your costs. That’s the key to no-surprises investing.

At the time this article was written, the author held positions in SCHB and SWTSX. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.