ETFs vs. Mutual Funds: Breaking Down Expense Ratios
Although ETFs offer many potential advantages over traditional actively-managed mutual funds, the most commonly-cited benefit is perhaps the easiest to grasp: lower expenses. In order to cover their costs–teams of analysts and pricey analytical tools used in pursuit of alpha–mutual funds typically always charge expense ratios in excess of 1% (and many times north of 2%). Because ETFs seek to passively replicate a benchmark, they are able to charge much lower expense ratios–as low as the 4 basis points charged by SCHX (see the 25 cheapest ETFs).
Most investors are aware that ETFs charge lower fees than mutual funds, but not all fully grasp the impact that management fees can have on bottom line returns, especially over the long term. While a few basis points here and there may not seem like much in the short term, these differences in management fees can translate into big dollar amounts over longer periods of time. Consider a simplified portfolio made up of four mutual funds, including a U.S. equity fund, emerging markets fund, developed market fund, and total bond market fund. The mutual funds outlined below are some of the most popular available to U.S. investors, an combine to make a portfolio with a weighted average expense ratio of 2.16%:
|Weight||Ticker||Mutual Fund||Benchmark||Expense Ratio|
|40%||AGWCX||AIM Select Equity C||Russell 3000 Index||2.27%|
|20%||ACKBX||American Century Emerging Markets B||MSCI Emerging Markets Index||2.82%|
|10%||PNICX||Allianz NACM International C||MSCI EAFE Index||2.13%|
|30%||PFDCX||Allegiant Bond Fund||Barclays Capital U.S. Aggregate Bond Index||1.58%|
Now consider a similar all-ETF portfolio that passively tracks each of the indexes the mutual fund portfolio strives to beat. The gap between the expense ratios–also known as the minimum amount by which the actively-managed fund must beat its benchmark–is as much as 245 basis points, a significant hurdle for any manager to overcome every year.
Instead of trying to beat the Russell 3000 Index, IWN simply seeks to match it (and does so with impressive efficiency). VWO does the same with the MSCI Emerging Markets Index, while VEA and LAD seek to replicate the MSCI EAFE Index and Barclays Capital U.S. Aggregate Bond Index, respectively.
The result is a portfolio with a weighted average expense ratio of just 14 basis points, or 2.02% less than the all-mutual fund portfolio outlined above:
|40%||IWV||iShares Russell 3000||Russell 3000 Index||0.20%|
|20%||VWO||Vanguard Emerging Markets ETF||MSCI Emerging Markets Index||0.15%|
|10%||VEA||Vanguard Europe Pacific||MSCI EAFE Index||0.09%|
|30%||LAG||SPDR Barclays Aggregate Bond ETF||Barclays Capital U.S. Aggregate Bond Index||0.08%|
The Bottom Line
Now suppose that each of these portfolios returns 10% a year before expenses for the next 30 years. Mutual fund managers out there will no doubt point out that their funds may beat passively-indexed ETFs, but let’s just assume for a minute that markets are efficient and over the long term, active management doesn’t add value (as a boatload of academic evidence suggests). An initial $1 million investment in the all-mutual fund portfolio would become about $9.6 million after 30 years–not a bad return. But when compared to the hypothetical all-ETF portfolio, the difference is astounding. The four-ETF collection would stand at about $16.6 million, or about 72% more than the mutual fund investor:
|Portfolio||Wtd. Avg. Expenses||Initial Investment||Value After 30 Years|
That’s what Vanguard Group founder Jack Bogle calls the “tyranny of compounded costs,” a phenomenon common among mutual funds that ETFs were originally designed to avoid (see Bogle: ETFs Not Without Their Flaws). While the savings associated with ETFs might not seem dramatic on a fact sheet or Excel download from the ETF screener, the differences in expenses are magnified over the long term, and can make a huge impact on any portfolio’s bottom line.
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Jared Cummans contributed to this article.
Disclosure: No positions at time of writing.