Reasons ETFs are inexpensive

Reasons ETFs are inexpensive

The ETF industry is growing quickly, and ETF.com projects the $1.7 trillion market of U.S.-listed exchange-traded funds will grow exponentially in the next several years, thanks to increasing interest among both retail and institutional investors.

Why? Because ETFs have many inherent traits that allow them to stand out relative to competing mutual funds, and cost is one of the biggest—if not the biggest—advantage.

According to data we compile, the average U.S. equity mutual fund has an annual expense ratio of more than 1.40 percent, while the average equity ETF costs about 0.53 percent. And those are just averages. Our data show that the bulk of ETF money is actually invested in funds that have an average fee of 0.40 percent, or $40 per $10,000 invested.

Here are the three main reasons why ETFs are cheaper than mutual funds, both active and index-based:

1. ETFs Have A Unique Creation/Redemption Feature

In a mutual fund structure, when money flows in and out, it’s the mutual fund company’s internal trading desk that does all the buying and selling, which is a big part of the mutual fund fee structure.

With ETFs, the fund doesn’t even buy and sell securities, which streamlines the entire process and makes ETFs cheaper.

This is all linked to ETFs’ unique creation/redemption feature, which makes use of authorized participants (APs). APs are often deep-pocketed market makers, or large financial institutions.

When an ETF company wants to create new shares of a given fund, it turns to APs who buy the underlying securities that make up the portfolio. The AP delivers the underlying securities the ETF wants, and receives the exact same value in ETF shares, which can be sold for profit.

Conversely, the AP can buy back ETF shares from the market and hand them back to ETF issuers in an “in-kind” redemption of actual shares that has all kinds of tax advantages for the fund and for investors in that fund.

In the end, the ETF gets what it needs, and the AP pays all the trading costs and fees—APs even pay an additional fee to the ETF provider to cover the paperwork involved in processing all the creation/redemption activity. What’s more, in open-end mutual funds, investors are hit with costs every time a new investor comes into the fund, because there’s no AP to absorb the trading expenses.

The mechanism shields the fund from these costs, and helps keep the share price of the ETF in line with the fair value of underlying portfolio. That’s key to the ETF cost structure.

In closed-end funds, practically speaking, no one can create/redeem shares as a matter of course, meaning they can trade at big premiums or discounts.

2. ETFs Are More Tax Efficient Relative To Mutual Funds

ETFs rarely distribute capital gains, which is a taxable event. That’s primarily because they are index funds, meaning they have a lot less turnover than, say, an actively managed mutual fund.

But even when compared to index mutual funds, ETFs still have the upper hand on tax efficiency, thanks again to the creation/redemption mechanism.

When mutual fund investors ask for their money back, the mutual fund must sell securities to raise cash to meet that redemption. Moreover, when a mutual fund investor sells, the capital gains are spread out over the fund’s entire base, creating unwanted tax consequences for all the investors who aren’t selling shares. The ETF structure keeps that from happening.

Conversely, when an individual investor wants to sell an ETF, he or she simply sells it and an AP handles the transaction, even when it’s a huge liquidation. There’s no capital gains transaction for the ETF.

In a sizable sale of ETF shares, the AP can redeem those shares with the ETF issuer. To be clear, the fund company doesn’t go out and sell stocks to pay the AP in cash, but rather pays the AP, as noted above, “in kind” by delivering the underlying holdings of the ETF itself to the AP. There’s no sale, so there are no capital gains for the fund.

There’s no question that this mechanism works best for equity ETFs, compared with fixed-income ETFs, where turnover and cash-based creation/redemptions are more frequent.

But by and large, ETFs are far more tax efficient than mutual funds. And at the end of the day, the less you’re paying in taxes, the more you’re keeping in your pocket.

3. Vanguard’s Friendly Pressure

Maybe this is a bit of a stretch, but Vanguard’s low-cost model has done wonders over the past four decades to put pressure on fund fees in general and, more recently, on ETF fees. Vanguard’s corporate structure—it’s a mutually structured mutual fund company—means it always operates “at cost.” That, in turn, means it’s lowered fund fees as a matter of course as it’s grown.

Competitors could afford to ignore Vanguard for years, but no more. It’s now the biggest mutual fund company in the world, with around $2.3 trillion in assets under management, and the index funds that made it a wild-eyed insurgent a generation ago are now moving into the mainstream.

Moreover, there’s no question that post-2008-crisis investors have proven to be a lot more demanding when it comes to fees, and many ETF issuers have been cutting ETF expense ratios as they vie for new investor dollars.

Vanguard’s focus on costs—its fund expense ratios are based on assets under management—have kept downward pressure on costs to the extent that expense ratios drop as a matter of course as assets grow. It helps that Vanguard ETFs are a separate share class of its mutual funds—meaning it benefits from massive economies of scale.

Vanguard’s expense ratios are among the lowest in the industry, and it’s spawned plenty of competition in the pricing realm.

For example, Charles Schwab has responded to the Vanguard threat by going out of its way to make expense ratios on its in-house ETFs the cheapest in their respective categories.

Also, iShares, dogged by negative comparisons to Vanguard on the fee front once Vanguard began offering ETFs, silenced its critics with the rollout of its “Core” ETFs in October 2012. The world’s biggest ETF company thus became one of the low-cost sponsors, and with a vengeance.

Investors should smile that Vanguard founder John Bogle’s “costs matter” hypothesis has gotten so much traction in the world of ETFs.

Costs do matter, and maybe Bogle deserves a thank-you letter from investors everywhere.

(Source: ETF.com, with some edits)