With mutual funds and exchange-traded funds (ETFs), there are two primary sources of fees. Both kinds of funds charge what's called an expense ratio, an annual fee that covers the fund's management, administrative costs and marketing expenses. In addition, with mutual funds you pay a sales load, a commission that a broker gets when you buy a fund (front-end load) or sell it (back-end load). While there is no sales load with an ETF, a broker may charge a commission on its purchase or sale.
While ETFs generally have lower fees than mutual funds, that's not always the case. Also, some popular ETFs now can be bought without commissions, and many firms offer no-load mutual funds.
However, "a fund's sticker price may not tell the whole story," says my colleague Robert Bell, senior vice president of investment product strategy at Merrill. It's important to take your time to understand what you're getting and how much you're paying. Fees aren't the only consideration when evaluating a fund. You need to think about the total cost of ownership.
"Fees aren't the only consideration when evaluating a fund. You need to think about the total cost of ownership."
— Mike McManus, Managing Director and Investment Strategist, Chief Investment Office, Merrill Lynch
According to Bell, funds with lower expense ratios may still come with additional expenses that may not at first be apparent. Understanding these 'hidden costs' will give you a better idea of the true costs associated with an ETF or mutual fund.
These two questions can help you identify potential costs:
- What other costs are involved in buying or selling a fund? Because ETFs trade like stocks on public exchanges, their prices fluctuate according to supply and demand. That's not likely to affect your costs significantly if you're trading a popular fund that tracks a major index. But more specialized ETFs that trade less frequently may have a wider "bid-ask spread" — the difference between the price sellers want and what buyers are willing to pay. That spread will be evident when you place an order. You could end up buying at a relatively high cost or selling at a low one, adding to your costs.
Trading costs also indirectly affect shareholders of mutual funds — particularly in actively managed funds that buy and sell holdings frequently in trying to generate positive returns. (The managers of actively managed funds choose what a fund will invest in; passively managed ETFs or index mutual funds, in contrast, aim to approximate the performance of specified market benchmarks.) Those transaction costs, which may sometimes exceed a fund's expense ratio, have the potential to undercut its performance.
- Where in the market do you want to invest? Low-cost ETFs are great if you want a fund that tracks the S&P 500 or another popular market index. But in more niche corners of the market, such as small-cap stocks or emerging markets, some investors may prefer actively managed mutual funds, even if that means paying slightly higher fees. There are cases where the value of expertise can outweigh the cost of the fees.
Learn more about the new fund story experience that can help you more easily access and evaluate fund details, including performance and third-party ratings as well as what's in a fund and what its costs are.