Are ETF expenses really lower than mutual funds?

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Are ETF management expenses really lower than mutual fund management expenses?

Yes and no. When you look at the full range of ETF management expense ratios, you find the most ETFs have a management expense ratio under 1% per year. In contrast, the average expense ratio for mutual funds exceeds 1%, so obviously the majority mutual funds carry management expense ratios that are over 1% per year. Clearly, it would seem that ETFs are generally cheaper than mutual funds.

Nearly every ETF is a passively managed index fund

Not so fast, however. ETF management expense ratios appear to be lower than mutual funds, but that is largely because almost all ETFs are just passive index funds. When you think of ETFs as just exchange tradable passive index funds, then instead, you might start to ask why are ETF management expenses actually so high – rather than so low.

Why are ETF management expense ratios so high, when you can find both no load mutual funds and ETFs with substantially lower fees that passively track the very same indexes? These funds are doing the same thing and targeting the same result. Why pay more for your train ticket, if the train cars are all the same, they are going to the same destination, and they will arrive at the same time? Just so that you can trade EFFs intraday or some other supposed ETF advantage? Therefore, comparing the average ETF expense ratio to the average mutual fund expense ratio is a false comparison.

The fact that most ETFs are directly comparable to passive index funds tends to constrain the range of ETF expense ratios through competitive forces and professional and amateur buyer choice. In contrast, what could justify the much higher management expense ratios for mutual funds? In short, really nothing.

Actively-managed mutual funds just have more randomness and volatility of outcome within which to hide versus an index fund. High cost actively managed mutual funds attempt to justify their high expenses based on superior performance. However, the statistics indicate that their average performance results are inferior and increasingly so with an increasing time horizon. More on this below.

The comparison between ETFs and mutual funds is not simple. Until recently, every ETF was effectively a passively managed index fund. Recently, just a few highly constrained actively-managed ETFs have been brought to market, but these new active ETFs are constrained oddities that only account for a tiny percentage of the over $1 trillion in assets now invested in US ETFs.

Mutual funds need to report their detailed portfolio holdings only on a quarterly basis and, even then, there are some months delay in the release of these four quarterly portfolio composition reports relative to the actual date of each portfolio composition snapshot. In effect, reasonably accurate and current information about mutual fund portfolios is just not available. This allows mutual funds to execute changes to their portfolios without other securities market traders knowing their playbook and trying to game their trades. Therefore, the structure of mutual funds and the infrequent and delayed reporting of their holdings allows for the private revision of mutual fund portfolios and the execution of active, stock picking strategies.

In contrast, the portfolios of ETFs are known publicly on a current, almost real-time basis. This is an artifact of how ETF shares are created. In general, there are authorized market participants who are the only securities market intermediaries who are authorized to create (or destroy) ETF shares. When you buy ETF shares on an exchange, you are not interacting with the manager of the ETF. When you buy ETF shares via a broker intermediary, you are either buying existing shares from another ETF investor/trader or ETF shares are being created to be delivered to you, though behind the scenes cooperation between the ETF and its authorized participants.

As aggregate market demand for ETFs rises (/falls) the market value of the ETF can vary from the value of its underlying securities. This creates incentives for authorized participants to create (/trade-in) more shares by delivering (/receiving)  a basket of securities to (/from) the ETF manager.

This ETF share creation and destruction is done a large scale and not on a transaction order-by-order basis. If an authorized participant creates a block of ETF shares, these shares are held in their inventory until they are rather quickly moved onto the market. Authorized participants create ETF shares, when demand rises and they see an opportunity for profit in the arbitrage process between the ETF share market price and the value of the underlying index basket of securities. This is how trading expenses related to new ETF shares are externalized, when compared to the mutual fund share creation process.

In order to implement this process, the composition of the ETF must be known publicly and in real time during the trading day. The ETF tracks a published securities index, which defines the underlying securities and their relative quantities. An alignment of the value of the overall ETF relative to its underlying securities is maintained by competing market participants. There are many more details and nuances, but the basic point is that almost all ETFs are inherently passive index funds with portfolios known in real-time.

Volatility aids the actively managed mutual fund mirage

The reason why some mutual funds have even higher fees is simply that they are gouging their customers even more and are not likely to deliver the value-added that they imply they do. They hide behind market volatility, random or chance performance results, and the shell game of naive investor performance chasing and personal portfolio churning. Many active mutual fund investors move from one former winner to another former winner – often egged on by their brokers and financial advisors. Unfortunately, superior historical performance is simply not a predictor of superior future performance, while lower costs and fees are predictors of superior net performance. The increasing shift of investor assets into low cost no load index mutual funds indicates that at least a large minority of investors has caught on to this sham.

Generally, the Standard and Poors SPIVA active versus passive mutual fund scorecards show that the longer the time horizon, the greater the advantage of the passive funds and the more the mirage of active management disappears. See:

These effects are even more pronounced, when you look at the SPIVA data on the lack of superior performance persistence regarding individual active funds – versus just comparing active and passive fund group averages. Furthermore, the inferiority of active strategies is not just a US phenomenon. Uniformly across the various countries that have SPIVA reports available on line, when the time horizon increases active strategies are increasingly inferior.

On the other hand, ETF vendors are limited in how much more they can gouge their customers. Their ETF products are just passive index funds and are more obviously comparable to both lower cost ETFs and lower cost index mutual funds. This is not the case with high cost mutual funds, because the mutual funds and their industry sales agents claim that selected active mutual funds have skilled securities pickers, who can identify superior securities and avoid inferior securities before the fact. Their sales agents claim that active mutual funds are better than index funds. They claim that the fund managers are very smart, and that you do not have to settle for a “market return.”

Financial industry sales compensation affects fund recommendations

Actively managed mutual funds rely upon a compensated sales force to push them. Ask a typical “full service” broker or “financial advisor” about using only index mutual funds, and very often you will face derision about targeting a “mediocre” market return and not shooting high enough with your investment assets. More expensive, actively managed mutual funds are what get recommended on the basis of higher past returns that are naively projected to continue into the future. Do you think that the higher sales compensation related to these higher cost actively managed funds might affect the advice you get?

Now, ask a typical “full service” broker about ETFs – which are just exchange trade-able index funds – and the story is likely to change. You might hear that ETFs are probably a pretty darn good idea as an investment. Do you think that the much higher brokerage fees charged by full service brokers might affect the advice you get?

Through selective marketing tactics, active fund customers are sold on the fantasy that they are more likely beat rather than trail the market benchmark return. Unfortunately, a large segment of the individual investor population does not pay close attention to their actual results relative to the cheaper passive investment strategy alternative that is always available to them.

In addition, numerous financial research studies have shown that a large portion of high cost mutual funds just are “closet index funds” to a greater or lesser degree. Many higher cost mutual funds are really far more expensive than even their expense ratios would imply. For example, if 75% of the portfolio holdings of an “actively managed” mutual fund with a 2% management fee overall, simply matches the benchmark index and only 25% of the portfolio differs from the benchmark, then investors are grossly overpaying for three-quarters of that fund’s “closet index” holdings.

To begin with, a two percent management fee is a huge expense burden to make up across an actively managed mutual fund portfolio. Think of high mutual fund fees as having to start a marathon a few miles back. To make up for the extra miles (extra costs), the manager must run those extra miles before your money even gets up to the starting line. Meanwhile, the low cost passive index funds tracking the market have already started at the real marathon starting line and is likely to be far ahead.

Your active manager needs to be pretty darn good, because he or she has to run faster to catch up and move ahead. (Hint: the historical record shows that most will not catch up, but they will never refund their unearned fees.) Now, if the returns on three-quarters of the holdings of an actively managed “closet index fund” are destined automatically to match the benchmark return, simply because they actually are the benchmark, then victory in the race becomes far less likely. Because only 25% of the portfolio is actually “active,” those securities had better run very fast to make up for the high fee charged across an entire portfolio.

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