ETFs vs Mutual Funds: Comparing Expense Ratios

When you are comparing ETFs vs. Mutual Funds, the expense of owning each should be a factor you consider. A fund's expense ratio is the cost you pay for the fund's management. The single greatest factor here is the income of the actual fund manager. Expense ratio also includes fees paid for record keeping and other custodial duties, however. On the whole, the is no general rule regarding whether a mutual fund or an ETF is cheaper. Consider these insights to understand the expense of each option.

ETFs Have a High Trade Commission

When you purchase shares of an ETF, you are essentially purchasing a single market security. An ETF, or exchange traded fund, trades just like any other security listed on the market. You can buy a single share, and that share trades at the value of the sum of its underlying parts. Since you are purchasing a security on the open exchange, you will see a commission fee paid to your trader. This typically costs between $15 to $20 a trade, which can quickly add up if you are constantly switching your ETF holdings.

ETFs Require Active Trading

The main reason ETFs are designed to trade like securities is because investors want to have the flexibility to buy and sell the shares very openly and easily. It is common for an investor to change his or her position on an ETF multiple times within a few years. This can amount to a number of trades, and the commission on the trades will add up. This will be added to the management fee on the ETF, which is subtracted from dividend payments each term. Ultimately, if you trade an ETF frequently, you will cut into your profits.

Mutual Funds have a High Management Cost

Mutual funds are not traded on the open market like ETFs. An investor buys into a fund with a certain number of shares directly through the brokerage offering the fund. The commission paid to buy in is much lower or even non-existent, depending on whether an investor uses a brand name fund or not. Even though savings on the commission can be big, the biggest expense on a mutual fund is the fee paid to the fund manager, though. Mutual fund managers and service partners will require a big dip out of the fund's potential dividend each term. 

Mutual Funds Require Passive Trading

The good news with a mutual fund is, even though you pay a lot for the service you receive, you should be able to be passively involved in the fund for a long period of time. This can cut back on the expense you would incur from entering and exiting the fund regularly. Further, if you do locate a passively-managed fund, the expense ratio will be even lower since the fund itself is not incurring transaction fees. Therefore, the best model for saving money, either with a mutual fund or an ETF, is to buy in and hang on, avoiding extra costs due to trade. The more stable your investment, the less transaction fees you will encounter.

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