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Why are exchange traded fund (ETF) management expense ratios (MERs) lower than mutual fund MERs?

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My understanding is that the traditional mutual funds use part of the expense ratio for advertising of the mutual fund to increase the number of shareholders. I don't think ETF's are advertised as heavily or directly to potential investors.

Also, the statistics could be skewed because it seems like a lot of ETFs do not have active portfolio management and simply track a particular investment index. This would reduce the overhead expense of an investment research team to investigate and select the investments for the fund.

  • 2
    I believe it is the second item more than the first. I went to the circus and there were a ton of ETF sponsorship posters. – MrChrister Aug 5 '10 at 23:27
  • SPDRs are advertised quite a bit on television. – James Roth Oct 28 '10 at 18:31
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I think the 2 previous answers are missing the biggest component of the cost savings: Since ETFs are traded as stocks, you pay a commission every time you buy and sell an exchange-traded fund. In contrast, lots of the most popular funds (e.g. Fidelity funds) demand no commission when you trade in and out of them.

Even with commissions cheaper than they've ever been, those tiny commissions on ETF trades create a powerful psychological barrier for many common investors. Without them, no-transaction-fee funds can generate a lot of thrashing in, out and between funds, particularly when investors are afraid and reacting to news.

Why does that matter? Because the fund ultimately incurs transaction costs of its own as thousands of traders want in and out of a fund. If the trades in & out balance out, no problem - they don't have to add/remove from their positions in the stocks underlying the fund. But when fear's afoot, traders all tend to be running in the same direction, e.g. from higher-yielding international stock funds to small-cap domestic stock funds, from small -cap domestic funds to large-cap domestics, from large-cap to bond funds, from bond funds to money markets. And when the fear abates, they throw everything in reverse to get back in: another round of trading.

The funds have some strategies (futures/options) to mitigate some of the thrashing costs, but that only gets them so far. The biggest cost-saver is to eliminate the thrash entirely.

Investor-born commissions are a phenomenal mechanism for achieving that goal.

Finally, if you don't believe me, try the Wikipedia sub-article written precisely on your question: http://en.wikipedia.org/wiki/Exchange-traded_fund#Costs

  • It's not really that the commissions prevent churn, it's that the structure does. The funds only create or redeem ETF shares in baskets of something like 50,000 shares. This bulk processing is efficient. Afterward, the shares are on the stock exchange, and it's not the fund's problem anymore. (High-frequency traders will use the creation/redemption power to compete with each other and keep the price of the ETF accurate on the exchange: any inaccuracy is an opportunity for arbitrage.) – fennec Feb 8 '11 at 3:41
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Another reason some mutual funds are more expensive is that many companies contract out a 401(k) plan to a particular mutual fund provider, who present the employees with a fixed set of mutual funds to choose from. They have little incentive to keep down the cost of their funds, since a bunch of employees are stuck with them one way or another.

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