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Vanguard Total Stock Market Index Fund Investor Shares (VTSMX)'s expense ratio is 0.14% whereas VTI, its equivalent ETF, has an expense ratio of 0.03%. Why is the expense ratio of an index fund sometimes higher than its equivalent ETF?

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    Partly as the broker costs for a Unit Trust is lower as the fund manager does some of the work a broker does for ETF.
    – Ian
    Jan 20 at 12:17
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Because funds of different share classes are there to cater different account sizes.

The actual equivalent of VTI is Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) if account size is > US$10,000.

Now you may ask why VTI is 0.03% while VTSAX 0.04%. That is because Vanguard of VTSAX provides service, while the service of VTI is provided by your broker.

To put this into perspective, imagine that a person invested $3,000 (the minimum) into VTSMX (not VTSAX) and makes 1-hour of phone call per year to a Minimum Wage call center in the US, such cost to Vanguard is already $7.5/$3,000=0.25%.

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Adding onto base64's excellent answer, an ETF also avoids some of the liquidity costs incurred by open end funds. Since only authorized participants may trade shares directly with a fund, and only in large blocks, the fund manager does not need to worry about buying/selling shares to service individual account holders needs.

Imagine if you needed to cash out of your fund and your fund manager had to sell a portion of their portfolio to generate the cash to meet your request? That's expensive. The ETF model uses the market and active participants to handle these types of requests and, hopefully, passes the savings along in the form of lower expenses.

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    Although, in this particular case, VTI is huge and the number of owners is huge too. The economy of scale probably means that the fund has no greater problems than the ETF in maintaining its balance, no? (This is just a guess on my part, would like to have it confirmed or refuted!)
    – davidbak
    Jan 20 at 5:07
  • Good point. A large fund (really any fund) should be able to keep enough cash on hand to handle redemptions. The problem is that it's impossible to predict, with absolute certainty, what future redemptions will be. You either end up with too much uninvested cash dragging down returns or not enough to cover all future redemption scenarios. Admittedly, I'm getting a little off topic here and this won't necessarily affect the expense ratio... Jan 21 at 14:56
  • I recall my education in this topic when my dad sold shares of a big mutual fund on my behalf for college expenses. They transferred $20000 worth of shares in Eastman Chemical to me. By the time it was sold I added a few cents per share so all's good, but it was a lesson in reading the prospectus fine print.
    – user662852
    Jan 23 at 17:43

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