The first thing people talk about when they talk about ETFs is their low fees. And it’s true: While the average U.S. equity mutual fund charges 1.42 percent in annual expenses, the average equity ETF charges just 0.53 percent. If you look at where the bulk of ETF money is actually invested, the average fee is an even lower 0.40 percent. In other words, investors tend to gravitate to the lowest cost funds, such as the S&P 500 SPDR (NYSEArca: SPY), which charges just 0.09 percent in annual fees. But fees are low in the ETF space no matter whether you’re looking at stocks, bonds, commodities or anything else. At IndexUniverse.com, we’ve created a well-diversified model portfolio of ETFs—complete with U.S. stocks, international stocks, emerging market stocks, bonds and commodities—with a blended average fee of 0.14 percent!
Try doing that with mutual funds.
More Efficient Than Mutual Funds
ETFs are cheaper than traditional mutual funds for many reasons. For starters, most ETFs are index funds, and index tracking is inherently less expensive than active management. But index-based ETFs are even cheaper than index-based mutual funds. So what gives?
It comes down to the way mutual funds and ETFs relate to their investors.
How A Mutual Fund Works
When a mutual fund receives a “buy” order from a new investor, it has a lot of work to do. First, it must process the order internally, recording who and how much money was deposited with the firm. It must send out confirmation documents, and handle any compliance issues. Then, the fund’s portfolio manager must go into the market and invest the money, buying and selling securities and paying all the necessary spreads and commissions involved.
And when investors sell, the process goes in reverse. That's a lot of hands-on management—and paperwork. And it ends up costing the fund a lot of money (which it passes along as higher fees).
With ETFs, it’s easier. When investors want to buy shares of an ETF, they simply enter an order with their brokerage. And … that’s it.
For most investors, ETF trades take place with other investors, and not with the fund company itself. That means the fund company doesn’t have to process your order; doesn’t have to mail you the same documents; and doesn’t have to go into the market to process your order.
Less work = lower costs. Point 1 in ETFs’ favor.
But how do ETFs actually invest money in the market if they have limited interactions with individual investors?
The answer to that lies in something called the “creation/redemption” process, which is the key to understanding how ETFs function.
>> NEXT UP: WHAT IS THE CREATION/REDEMPTION MECHANISM?