Look inside the portfolio of any long-term investor, and you’re likely to find ETFs (exchange-traded funds) and mutual funds. Both of these assets offer an excellent way for investors to incorporate diversity across their investments, which means it may be valuable for you to understand a little about how they work and the fees involved.
Both ETFs and mutual funds operate by pooling investors’ money together to buy partial ownership of many different assets. There are just a few fundamental differences between the two.
ETFs buy and sell assets based on mechanical rules that maintain an optimal composition for the fund – for example, “The 500 largest companies listed in the United States”. In practice, this means that when the 500th largest company is overtaken by another, the fund will automatically sell its shares and buy into the replacement.
Mutual funds instead rely on the expertise of fund managers to buy and sell assets.
We’ll discuss the advantages and disadvantages of each in articles to come. For now, it’s important that we discuss their fees.
The Expense Ratio
Every fund must disclose what is called an Expense Ratio (ER). It’s a figure that reflects its total fees – from management fees (the cost of either algorithms or human fund managers reviewing and updating a fund’s assets) to administrative expenses (for example auditing, office expenses, and other necessary operating costs). As a rule of thumb, the lower a fund’s ER, the less added value its manager provides.
As with everything in life, price is not the only variable to consider. What matters is the value you get for the price you’re paying.
It’s a legal requirement for funds to disclose their ERs, which is helpful for investors. When two funds offer the same value, yet one has a cheaper ER, it may be the better of the two options. With that said, simply hunting for funds with low ERs may not be the best move. An exceptionally low ER can imply that managers are cutting on essential operating costs like research in order to appear more attractive in the short term. At the other end of the spectrum, particularly high ERs are also to be treated with skepticism – it’s not uncommon for funds who market themselves as tracking “trending” assets – like cryptocurrencies in our current market – to include particularly high margins in their prices.
Your wallet size also dictates just how much a fund’s expense ratio matters. Large pension managers with millions to invest are usually able to negotiate more attractive ERs than amateur investors.
In addition to a fund’s ER, there are a number of additional fees to be aware of.
Placement fees are charged by some banks and investment platforms for access to the funds they provide. A high placement fee is something to avoid.
Another is the bid/ask spread. When managers buy and sell assets for a fund, they reach out to brokers who require a commission. That commission will need to be passed on to investors, and its size depends on how much bargaining power the fund holds.
The final fee is the liquidity cost. Large funds needing to buy or sell large numbers of assets at particular moments may face paying premiums or taking on losses that need to be covered by investors.
Conclusion
As with everything in life, price is not the only variable to consider. What matters is the value you get for the price you’re paying.
This article can be used as a reference guide while you become familiar with investing fees. If you think that will be helpful, just bookmark it for later. Wishing you the best on your investment journey.
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