Why ETFs are cheaper than Mutual funds? All you need to know about
ETFs have been doing the rounds in the market for a long time and have penetrated deeply into investor portfolios. Thanks to their liquidity, accuracy, and ease of understanding, these instruments have proven to be a boon for retail and institutional investors.
The most eye-catching amongst them is their lower costs. But why are these ETFs cheaper? The answer to this question is the ETF structure and how they operate.
Reasons why ETFs are cheaper?
Most ETFs are passive index funds. These funds generally track the underlying index with full or partial replication, thereby reducing the need for actively managing a fund which is usually the case with mutual funds.
Index tracking mutual funds are also expensive as compared to similar ETFs. Let’s suppose an investor wants to sell or buy an ETF; the investor does the same by directly placing an order with the broker.
However, to transact in a mutual fund, the investor needs to contact the fund manager, sell these units in the secondary market, and revert a tedious process that costs more.
The mantra is simple “less work = fewer costs”
ETFs use an “in-kind” method of creation and redemption of shares.
What is the in-kind creation process?
An in-kind creation process means that if an investor has a portfolio precisely similar to the underlying security basket of the ETF, then the investor can directly exchange this portfolio for the equivalent number of ETF shares.
The option was available only to large sum investors or institutional investors, but now it is available for retail investors too.
This type of transaction reduces the number of transactions an investor must go through to get the ETF shares. Thus, the transaction fee and paperwork commission are not there.
What is the in-kind redemption process?
An in-kind method of redemption process is also in place. The investor can opt for an in-kind redemption process by exchanging the ETF share for underlying securities rather than selling them in the secondary market.
The above-mentioned process again enables the fund to buy and sell securities without entering the secondary market, leading to a reduction in paperwork and other transaction costs, thus allowing a cost-effective running of the fund.
Consumers, thus, benefit in the form of a lower expense ratio.
Administration charges are also one of the key factors which increase the cost of holding mutual funds vis-à-vis ETFs.
Since ETFs trade on the stock exchange. The fund house need not get involved in the everyday transactions of the fund. The issuer needs to come into the picture only during the creation and redemption process of the shares.
Consider this: When investors trade Tesla (TSLA) shares, the company has no direct involvement. ETF issuers have no direct participation when investors sell their shares on similar lines.
On the other hand, a mutual fund needs to be involved in every transaction since all transactions happen through him.
Mutual funds charge an annual 12b-1 fee.
What is a 12b-1 fee?
It is an expense that the mutual fund undertakes to promote and market the mutual fund to increase its AUM.
If you wonder whether they transfer these expenses to their investors, the answer is – YES, they transfer these expenses! The world is not a fair place after all.
According to the Securities and Exchange Commission (SEC), “these fees are deducted from a mutual fund to compensate securities professionals for sales efforts and services provided to the fund’s investors.”
The original motive of sharing these costs was to increase the popularity of the mutual funds by lowering the expenses of mutual fund houses, but in today’s world, where they have infiltrated almost every portfolio, charging this fee is a bit controversial.
ETFs are far less expensive than mutual funds because they do not charge 12b-1 fees, thus, they have a lower expense ratio.
The bottom line is that ETFs are significantly cheaper than other such investment vehicles due to their operation and structure.
ETFs are intrinsically more cost-effective than mutual funds since they trade on exchanges like stocks, eliminating many operational fees of running a mutual fund.
Furthermore, because most ETFs are passively managed and linked to an index, issuers have fewer costs to pass on to investors, resulting in reduced expense ratios.