Investors who buy into exchange-traded funds (ETFs) typically see lower fees than those charged for mutual funds. In 2022, the average expense ratio for an index ETF was 0.16%.The average cost for an actively managed mutual fund was 0.66%.Overall, the average fees for investors have seen a steady decline.
Key Takeaways
- Mutual fund companies have steadily cut their fees to compete with low-cost exchange-traded funds (ETFs).
- ETFs have lower costs on average than passively managed mutual funds and don't charge 12b-1 fees.
- The expense ratio is the cost of the mutual fund, including any management fees, fees for expenses, and 12b-1 fees, and expressed as a percentage of the total assets under management.
Mutual Fund Fees
The expense ratio is reported in every mutual fund prospectus, which details the costs to investors. The expense ratio is the total cost of the fund, including any management fees, fees for expenses, and 12b-1 fees. It is expressed as a percentage of the total assets under management. Mutual funds may include all or some of these fees:
- Management fees compensate those who trade the fund's portfolio.
- 12b-1 fees pay marketing costs and, sometimes, employee bonuses and cannot exceed 1% of the investor's assets.
- Account fees may apply to accounts that fall below a specified value.
- Redemption fees may be imposed to penalize short-term trading.
- Exchange fees may be charged for moving money between funds at the same company.
- Purchase fees may be levied at the time shares of a fund are bought.
The fee to purchase shares is the "load fee" paid to the broker or agent who sells the shares. This is a one-time charge, typically 5% of the amount invested. The legal maximum is 8.5%.Many "no-load" funds are available so investors can avoid this cost.
ETF Fees
Exchange-traded funds have costs, but they are not reflected in their statements. They are deducted daily from the net asset value of the fund. The administrative costs of managing ETFs are commonly lower than those for mutual funds.
Most ETFs are passively managed funds and always "no-load," meaning there is no purchase fee. Online brokers offer commission-free ETF trades. Unlike mutual funds, ETFs do not charge annual 12b-1 fees. These fees are advertising, marketing, and distribution costs that a mutual fund passes to its shareholders. Each investor pays for the fund company to acquire new shareholders.
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ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund. The sale of ETF shares does not require the fund to liquidate its holdings or generate tax implications from capital gains, keeping costs to investors lower.
What Is the Difference Between an Actively or Passively Managed Mutual Fund?
An actively managed fund has a manager, or a team, devoted to buying and selling stock frequently. Their goal is to beat the performance of a particular benchmark index.
A passively managed fund is set up to mimic a specific benchmark index. No investing decisions are made. The only buying and selling are done to mirror changes in the index.
How Do Capital Gains Affect the Fees of Mutual Funds and ETFs?
When mutual fund shareholders sell shares, they redeem them from the fund directly. That often requires the fund to 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. Mutual fund shareholders pay income taxes on those distributions, and the fund company handles transactions, increasing its operating expenses. Since the sale of ETF shares does not require the fund to liquidate its holdings, its costs are lower.
What Is In-Kind Redemption for an ETF?
ETFs use in-kind creation and redemption practices to keep costs down. Investors can trade a collection, or basket, of stock shares that match the fund's portfolio for an equivalent number of ETF shares. An investor can redeem shares by swapping them for an equivalent basket of stocks rather than selling them on the secondary market. The fund does not have to buy or sell securities to create or redeem shares, reducing the paperwork and operational expenses incurred by the fund.
The Bottom Line
Exchange-traded funds (ETFs) investors typically incur lower fees than those charged for mutual funds, and mutual fund companies have had to curtail fees to compete with low-cost ETFs. Most ETFs are passively managed funds, always "no-load," with lower operational, marketing and administrative costs passed to investors.
