ETFs have found their way into countless portfolios in recent years as investors of all sizes and experience levels have grown to embrace the instant diversification, unparalleled transparency, and intraday liquidity that these financial instruments have to offer.
Another reason, and perhaps the more obvious one, that has prompted many to jump ship from mutual funds and into exchange-traded products is the glaring difference in costs; it’s no secret that ETFs boast tremendous cost-efficiency benefits over their mutual fund counterparts.
A lot of noise has been made about the cost-advantages that ETFs boast, and for good reason: there’s no more surefire way to improve your returns over the long-haul than by reducing the amount you pay in management fees.
Below we offer 5 visual examples to illustrate these sometimes seemingly trivial cost differences between the two types of financial instruments.
1. Why Expense Ratios Matter
Most investors are keen enough to recognize that a small difference in expense ratios can lead to a big difference in returns over a long enough time horizon. But just how powerful is the ETF cost-advantage? Consider the following hypothetical example: let’s assume you invest $100,000 over the course of 30 years and generate a 6% return annually. On one hand, you could invest in a mutual fund that charges 1.5%, or you could opt for an ETF that offers comparable exposure but costs only 0.35%.
Be sure to also check out our Free Mutual Fund to ETF Converter Tool.
After 30 years, the power of compounding returns and low-cost investing is clearly showcased; the ETF investment leaves you with a portfolio totalling $520,098 while the mutual fund investment has grown to a much paltrier $374,532.
2. Surviving a “Flat” Market
The higher fees you are likely to pay for a mutual fund can take their toll even when the market isn’t necessarily going against you. Consider the following hypothetical example: let’s assume you invest $100,000 in a mutual fund charging 1.5% in fees annually. Now let’s suppose that over the next 30 years the market turns in a flat performance.
Even if the market isn’t going anywhere, your mutual fund investment shrinks rather quickly since you’re left paying the pricey management fees each and every year. After 30 years of being stuck in a sideways market, your $100,000 investment can shrink by nearly 40%, leaving you with $63,546.
3. Investor Profit vs. Fees Paid
Some mutual funds are notorious for charging expenses that go beyond the stated management fee. One of these fees is a front-end load, which is an expense you incur at the time of purchasing your mutual fund shares. For example, if a fund charges a 5% front-end load (some can charge even more) and you invest $100,000, your initial investment will come out to only $95,000 after you pay this fee. Now let’s suppose you invest $100,000 in such a fund; the chart below compares your profit and the fees you end up paying over the course of five years, assuming the fund costs 1.5%, charges a 5% front-end load, and returns 5% annually.
When all is said and done, you end up earning $12,830 – just a little bit more than the fees you incurred, which total $12,642, since making your initial investment five years ago. The point here is that the front-end load can take a meaningful bite out of your returns, leaving your investment “in a hole” right off the bat.
4. 12b-What Fees?
Load fees can be a burden as the above example clearly demonstrates, but the list of quirky expenses you’re bound to encounter when shopping for a mutual fund doesn’t end there. If you’re not careful enough in reading the fine print, you could be left with a mutual fund that boasts a 12b-1 fee. So what exactly is that? In the simplest terms, the 12b-1 fee is the annual marketing expense, included in the management fee, that many mutual fund companies incur, and ultimately pass off to investors [see also When Reading the Fine Print Matters for ETF Investors].
Here is a breakdown of this much-debated fee:
According to the Investment Company Institute, more than half of all mutual fund share classes include 12b-1 fees as part of their operating expenses. Why should investors be left paying for a fund’s administrative and promotional expenses? That’s a good question. The pesky 12b-1 fee is just one of the many reasons why mutual funds can be a less-than-ideal instrument for cost-conscious investors.
5. Comparing Apples to Apples
Critics of ETFs are quick to point out that many of the cost comparisons drawn between these vehicles and their mutual fund counterparts is not exactly “apples-to-apples” so to say. In an effort to further showcase the cost-advantage that countless ETFs boast, let’s consider the following examples that pits two nearly identical funds against one another. Let’s suppose you wish to add emerging markets exposure to your portfolio. Now let’s assume that after doing your research you’ve narrowed down your choices to a mutual fund and an ETF, both offered from Vanguard, which is perhaps the most notable low-cost leader in the industry.
On the one hand, you have VEIEX, a mutual fund that charges 0.33% and doesn’t have any load fees; one potential drawback however is the fact that this mutual fund requires a minimum investment of $3,000. On the other hand, as suggested on VEIEX’s profile page, you could opt for the ETF version of this mutual fund; the Emerging Markets ETF (VWO ), which charges 0.15% in expense fees and doesn’t have any load fees or a minimum investment requirement. Now let’s suppose you invest $100,000 in each of these two vehicles over the course of 30 years, assuming 6% annual returns:
The difference between the two investments after 30 years is by no means jaw-dropping; the mutual fund leaves you with $523,060 while the ETF alternative leaves you with a slightly heftier $550,460. While this difference may not be staggering, it does amount to $27,400 after 30 years, which are additional funds that you could be putting to work if you simply opt for the lower-cost ETF alternative.
The Bottom Line
ETFs have been embraced by investors for their ease-of-use, unparalleled liquidity, and perhaps most importantly because of their cost-efficiency. Exchange-traded products offer numerous cost-advantages, as illustrated in the examples above, over traditional mutual funds—making these vehicles the preferred choice for most cost-conscious investors, and especially those with a long-term investment horizon.
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Disclosure: No positions at time of writing.
