ETFs vs. Mutual Funds - Which has Lower Expenses?

Exchange Traded Funds (ETFs) are touted for their low expenses. This is true for many traditional ETFs, such as the SPDR (SPY), which tracks the S&P 500 Index and carries an expense ratio of around 0.10%. But some ETFs charge much more. For instance, most single-country ETFs charge more than 0.50%. ETFs that focus on a specific industry will also be close to 0.50%. There are even ETFs that charge 0.95% So, just because it is an ETF does not mean it has a low expense ratio.

Mutual Funds that track similar sectors though also have higher expense ratios. So that, even with these high expense ratios, ETFs usually still have lower expenses than comparable mutual funds. But does this mean that ETF are the cheapest option? The low-expense advantage of ETFs may be a mirage because you must pay commissions to buy and sell ETFs.

If you invest regular sums of money each month, an ETF will cost you much more than would a similar mutual fund. If you are putting $1000 a month away and use Sharebuilder’s $4 commission per trade, that still adds 0.40% of expense. Granted, each year you hold the ETF dilutes this expense but it would take a number of years to make up the small advantage that ETFs have over comparable index funds.

If you plan on trading frequently, any cost advantage would be lost. ETFs do have other advantages for frequent traders, but the expense ratio is not one of them.

But there is one more expense that most don’t consider and is much harder to quantify. Every time you buy or sell an ETF, like stocks, you implicitly pay a hidden fee called the ‘bid-ask spread’. This spread is the difference between the buying (bid) and selling (ask) price of the same ETF. This ’slop’ between the bid and ask price is another profit center for the broker handling the transaction.

SPDRs (SPY) probably have one of the lowest bid-ask spreads because it is so heavily traded and there is a heightened interaction between the specialists, market makers, and arbitrageurs. The average bid-ask spread for the SPDR was reported as 0.09%. Bid-ask spreads for such heavily traded ETFs can be quite small but for others, such as certain emerging market ETFs it can be quite large (e.g., for certain emerging market ETFs). Even a spread of 0.09% adds to your cost factor, making no-load mutual funds look more attractive.

Are there reasons to buy ETFs? Yes! Is it because they are ‘cheaper’ than mutual funds? Probably not.