I’ve already written about Why ETFs Beat Individual Stocks, but did you know ETFs also beat mutual funds? Though Exchange Traded Funds (ETFs) and mutual funds both allow investors to own a group of investments by making just one purchase, ETFs have several distinct advantages over mutual funds:
ETFs vs mutual funds
- ETFs have Low Minimum Investment and Trading Flexibility
- ETFs typically have lower Expense Ratios
- ETFs offer trading flexibility
- ETFs also offer some tax advantages
- ETFs offer protection against possible fraud
- ETFs have opportunities for options and short selling
ETFs usually have lower expense ratios
All mutual funds and ETFs have an expense ratio. This is a fee charged to shareholders to cover the costs that the firm incurs to manage the mutual fund or ETF. Expense ratios are expressed as an annual percentage, such as 1.00% or 0.75%. An investor who owns $10,000 worth of a mutual fund with an expense ratio of 1.00% will pay $100 per year in fees for the “privilege” of owning the fund.
The good news is that ETFs generally have a much lower expense ratio than actively managed mutual funds. They also tend to have lower expense ratios than those of comparable index funds, sometimes even lower than the index an ETF tracks. Why? There isn’t much “trading” going on within the fund. That automatically lowers the cost of maintaining the ETF.
Average expense ratios of ETFs and mutual funds:
- Actively managed mutual funds: 1.50%
- Index mutual funds: 0.50%
- ETFs: 0.40%
Why expense ratios matter
Though the differences between the average expense ratios of ETFs, index funds, and actively managed mutual funds might seem small, over time they affect your investment returns (profits) substantially. The table below lists the returns you would get from an ETF, index mutual fund, and actively managed mutual fund with average expense ratios, assuming a $10,000 investment held for 30 years, with returns (before taxes and expenses) of 10% per year — which is roughly the annual return on stocks over the past 50 years or so.
|Expense Ratio||Total Before Expenses||Total After Expenses||Cost of Expenses|
With an expense ratio of five one hundredths of one percent (0.05%), the Focus Morningstar US Market Index available to Scottrade customers commission FREE, you’re able to grow your investments in ways that other investments simply cannot.
Also, notice that the tiny 0.10% difference between the expense ratio of an ETF and an index fund adds up to a difference of $4,226 in fees over 30 years. The 1.10% difference between the expense ratio of an ETF and that of an actively managed mutual fund totals $40,846 in fees over 30 years. If all else is equal between two investments, the investment with the lower expense ratio is most likely your best choice.
Lower expense ratios give ETFs a distinct advantage over mutual fund investing.
How to buy ETFs
You’ll have to open an account at a brokerage company. Click the links below to get further information:
- Scottrade – you can buy Focus Morningstar ETFs commission free!
- Etrade – E*Trade helps you get started investing in three easy steps
- TradeKing – offers regular trades and broker assisted trades for only $4.95
- tradeMonster – offers mobile trading
- Zecco – has commission free trades available
- ShareBuilder – invest for only $4 per trade on an automatic investment plan