Understanding Fees: Mutual Funds & ETFs

I was recently watching a news program in which a commentator generalized Exchange Traded Funds (ETFs) as “cheap” and mutual funds as “expensive”. Too often, we dismiss all ETFs as index following and therefore “cheap” and all mutual funds as being actively managed and therefore “expensive”. In reality, an ETF or a mutual fund is simply a packaging solution that can contain a variety of assets and styles of investing. In order to properly assess whether a particular solution is priced appropriately, we must first dissect the package to understand which investments are included and how they are managed.

The biggest cause for differences in fund pricing is whether the fund is actively managed or passively follows an index. An actively managed fund often requires research, expertise, and active trading in the fund to execute on the strategy. This differs from a passive strategy that simply replicates an index thereby avoiding the need for expertise or research and has infrequent trading requirements.  Not surprisingly, passive funds are a lot less expensive than active funds.

This difference in pricing is evidenced not only in ETFs, but in mutual funds as well. In a review of the 609 mutual funds and ETFs in the Morningstar Large Cap Blend Category, there are 211 index funds and 398 actively managed funds. The passive index funds had an average expense ratio of 0.30% whereas the active funds averaged 0.89%.

Breaking those statistics down further, we find the average passive index fund expense ratio that is packaged as an ETF is 0.31% while the average passive index fund packaged as a mutual fund is 0.28%. In this case, the average mutual fund is cheaper than the average ETF, which runs counter to the generalized assumptions we often hear in the news.

On the active side, the average active ETF in the category runs at an expense ratio of 0.81% while the average active mutual fund runs at 0.89%. Noticeably higher than the passive funds, but between ETFs and mutual funds there is not much disparity in the pricing.

While it is prudent for investors to be price conscious in selecting which funds to implement, it is important to understand that packaging is just packaging and does not represent the nature of the underlying investment. A more expensive fund may be worth it if you feel there is ample expertise to deliver the desired outcomes to an overall portfolio.

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The assertions and statements in this blog post are based on the opinions of the author and Liquid Strategies. The examples cited in this paper are based on hypothetical situations and should only be considered as examples of potential trading strategies. They do not take into consideration the impact that certain economic or market factors have on the decision making process. Past performance is no indication of future results. Inherent in any investment is the potential for loss.