ETFs Are Not Always Cheaper

Do exchange-traded funds or index mutual funds offer lower-cost exposure to similar indexes? It may be reasonable to expect ETFs to charge lower expense ratios than their index mutual fund counterparts. After all, ETF managers do not have to maintain accounts for individual investors like index mutual funds, which helps reduce their administrative expenses. In order to evaluate whether this structural advantage actually translates into lower costs, we matched ETFs and index mutual funds that track the same indexes within several Morningstar Categories and compared their annual report net expense ratios. While differences in expense ratios do not tell the whole story, they offer a good starting point, because they often represent the largest and most predictable component of the total cost of owning a fund.

We limited our data set to broad market-cap-weighted stock and bond indexes tracked by both ETFs and index mutual funds. This removes the vast majority of ETFs from our study because most track specialty indexes that are not available in a mutual fund format. We eliminated funds that were launched after Jan. 1, 2013, and grouped the remainder by Morningstar Category. Each category also had to include at least three index mutual funds and three ETFs as of April 2014 in order to remain in the sample.

Exhibit 1 illustrates the asset- and equal-weighted net expense ratios for each category of ETFs and index mutual funds we examined, based on their 2013 annual reports. The equal-weighted expense ratios suggest that ETFs offer substantial cost savings. On this measure, only the ETFs in the long government bond category were not cheaper than their mutual fund counterparts. However, outliers can have a significant impact on these averages. The asset-weighting approach mitigates this problem because low-cost funds tend to attract a disproportionate share of assets. It also better reflects the average investor's experience.

Not surprisingly, the mutual funds' asset-weighted expense ratios are generally lower than the equal-weighted expense ratios. The difference between the asset- and equal-weighted expense ratios is less pronounced among the ETFs in the sample. One possible explanation is that institutional investors may be attracted to funds that offer the best liquidity, such as  SPDR S&P 500 (SPY) and  iShares MSCI Emerging Markets (EEM), even if they do not carry the lowest fees. This is because they are the cheapest to trade in large quantities and often have deep options markets. These features are particularly attractive to large institutional investors, who may use these funds for short-term asset-class exposure and hedging. These funds are often early entrants. Once they build a liquidity advantage over their peers, there may be less pressure on their fees.

The asset-weighted expense ratio comparison narrowed ETFs' cost advantage in every category. Only three of the 14 ETF categories sport a lower asset-weighted expense ratio than their mutual fund counterparts. They look more expensive in eight of the categories.

Institutional and Retail
Index mutual funds' institutional share classes pull the asset-weighted average expense ratio down. However, they require high minimum investments or are only available on select retirement plan platforms. In order to separate these restricted share classes from those that are broadly available to individual investors, we grouped the mutual fund share classes by minimum investment. Those with a minimum investment of $10,000 or less fell into the retail category, and those with minimums above this threshold went into the institutional group. We also categorized all share classes that require an intermediary to access as institutional. Each retail and institutional category needed at least three funds in order to remain in the sample.

On an asset-weighted basis, ETFs were slightly cheaper than the mutual funds' retail share classes in six of the 10 categories included. However, the institutional share classes were cheaper than the ETFs in every category except for mid-growth. ETFs look like a better bargain on the equal-weighted expense ratios, though the institutional share classes narrowed the gap in five categories.

The Vanguard Factor
The results of this analysis are also sensitive to whether Vanguard funds are included. Because Vanguard prices its funds at cost, many of its index mutual funds are cheaper than ETFs from other providers. Vanguard's index funds have significant influence on the asset-weighted averages because they tend to be among the largest mutual funds in each category. However, Vanguard has a smaller share of the ETF market. Vanguard funds accounted for 80.0% of the assets in our index mutual fund sample and 32.3% of the assets in the ETF group.

After removing Vanguard's funds, ETFs look cheaper than their mutual fund counterparts on an asset-weighted basis in every category included except foreign large blend. The asset-weighted expense ratios for Vanguard's ETFs are slightly lower than the corresponding values for its mutual funds. All of Vanguard's U.S. ETFs are separate share classes of its mutual funds. Vanguard charges the same expense ratio for the Admiral and ETF share classes.

Fee Trends
We extended our analysis back 10 years to uncover fee trends, including funds that are no longer surviving. As before, each category had to have at least three funds to qualify for inclusion. Based on these funds' annual reports from 2004 through 2013, ETFs' asset-weighted cost advantage relative to their index mutual fund counterparts in the large-blend category fell to 0.01% from 0.10%. As the chart below illustrates, this was almost entirely because of a decline in asset-weighted index mutual fund expenses.

During this time, some of the most expensive index mutual funds shut down and new funds entered with lower expense ratios. However, most of this decline resulted from assets moving to the lowest-cost mutual funds. The reduction in the equal-weighted mutual fund expense ratio was much smaller. On this metric, large-blend ETFs continue to look considerably cheaper than the mutual funds in the category.

The fact that the equal-weighted mutual fund expense ratios were significantly higher than the asset-weighted expenses suggests that there are still a number of expensive index mutual fund share classes with very few assets. The chart below illustrates this point. It shows the percentage of assets in the large-blend category invested in mutual fund share classes and ETFs with expense ratios above the median for each vehicle.

In many cases, there were cheaper funds that offered identical exposure. The market was efficient in the sense that money tended to flow toward the lowest-cost options. But it is surprising that the most expensive funds survived at all. Inertia is a powerful force. These funds tend to be older, and investors may be deterred from selling them to avoid capital gains and the tax liabilities they could trigger. Some of the more expensive mutual fund options may also gain new assets through retirement platforms, where investors have limited choices.

The difference between the asset-weighted and equal-weighted expense ratios for ETFs was much less pronounced. This may be because it is often easier for investors to switch among ETFs, while some mutual funds enjoy a more captive audience through retirement platforms. Similar to their mutual fund counterparts, expensive ETFs did not garner significant market share in the large-blend category.

The fee trends are similar for the large-growth, large-value, mid-blend, small-growth, and small-value categories. Asset-weighted mutual fund expense ratios have declined during the past decade. However, the asset-weighted differences between ETF and mutual fund expense ratios have not changed much, with the exception of the large-growth category. ETFs' asset-weighted cost advantage in each category was also much smaller (and in some cases negative) than the equal-weighted cost advantage, suggesting that there were many expensive mutual fund share classes with few assets.

This analysis shows that investors have plenty of low-cost options, regardless of whether they choose to go with an ETF or index mutual fund. There are expensive funds, to be sure, but they do not usually attract much attention--nor should they, given the multitude of increasingly inexpensive options that investors have at their disposal. The difference in expenses between the two vehicles is small, at least on an asset-weighted basis. As measured on the basis of fees alone, one vehicle is not categorically better than the other.

While the expense ratio is the most visible--and usually largest--component of the total cost of owning a fund, investors must take additional factors, such as tax efficiency and trading costs, into account to assess the total cost of ownership.

Tax Efficiency
Market-cap-weighted index investing is fairly tax-efficient because it does not usually require turnover in response to changing fundamentals. Where the median active fund in the large-blend category had a median turnover of 46% in 2013, the corresponding figure for the median market-cap-weighted index fund was only 5%. ETFs build on this tax advantage through their in-kind redemption and creation process. This process allows managers to transfer low-cost-basis shares out of the fund in a tax-free transaction with the fund's authorized participants. The resulting incremental tax savings may give ETFs an edge over mutual funds that track the same indexes.

In order to assess the relative tax efficiency of index mutual funds and ETFs, we compared each group's median potential capital gains exposure, five-year tax-cost ratio--which measures aftertax returns at the highest marginal rate relative to pretax returns--and the frequency of capital gains distributions over the trailing five years through August 2014. For this analysis we grouped all funds into one of three categories: U.S. equity, international equity, and taxable bond. The U.S. equity ETFs in our sample appeared to be slightly more tax-efficient than index mutual funds according to each of the three metrics. International-equity ETFs also appear more tax-efficient than index mutual funds, but their advantage was smaller. This is partially because some foreign tax jurisdictions do not allow in-kind redemptions, which diminishes ETFs' structural tax advantage. Also, most international-equity funds' performance lagged that of U.S. equity funds over the five-year period analyzed, resulting in fewer capital gains and fewer opportunities for international-equity ETFs to leverage any potential tax advantage.

The picture was mixed for taxable-bond funds. Although the median taxable-bond ETF had the same tax-cost ratio as the median mutual fund and lower potential capital gains, taxable-bond mutual funds made capital gains distributions less frequently. Bond ETFs may not be able to use the in-kind redemption mechanism as effectively as their equity counterparts. Turnover tends to be higher for bond index funds because they sell bonds as they approach maturity. Bond ETFs may not be able to manage all of these trades through the in-kind redemption process. In addition, income tends to represent a larger share of the taxable distributions for bond funds than equity funds. ETFs do not have an advantage over mutual funds in mitigating the tax liabilities that income distributions trigger.

Trading Costs
Trading costs may put ETFs at a slight disadvantage relative to no-load index mutual funds. Investors buy and sell mutual funds at NAV, often directly from the fund issuer without paying trading commissions. In contrast, ETF investors usually pay commissions and are rarely able to trade at NAV, as ETFs tend to trade at (typically small) premiums and discounts to the value of their underlying assets. But because commissions are typically fixed fees, they become less significant as the size of the trade or the length of an investor's anticipated holding period increases. Many brokers also offer commission-free ETF trading programs, which help reduce this cost hurdle.

While trading commissions are the most conspicuous component of trading costs, indirect trading costs, such as the bid-ask spread and market impact of trading, can often be more important. The smaller the trade is relative to the ETF's trading volume and more liquid the ETF's underlying holdings are, the smaller these costs tend to be. Mutual fund investors ultimately bear some of these trading costs, too. The ETF structure largely externalizes these costs rather than spreading them among all investors.

When equity index mutual funds and ETFs track the same benchmark at comparable expense ratios, ETFs may be the better option for taxable accounts. The cost equation swings in index mutual funds' favor as the frequency of transactions increases or their size decreases (assuming liquidity isn't an issue). However, in many cases, the optimal vehicle is simply a matter of personal preference.

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