What are the costs of ETFs?

Like mutual funds, ETFs charge expense ratios to cover ongoing operating expenses. But they also have some costs that aren't associated with mutual funds.

Operating expenses

ETFs and mutual funds charge fees to cover ongoing operating expenses, such as advisory services, administration and recordkeeping, among other things. These fees are expressed as a percentage of fund assets and are commonly known as the expense ratio.

ETFs tend to have lower expense ratios than mutual funds. This is largely because most mutual funds are actively managed and charge higher expense ratios than their index counterparts. As the vast majority of ETFs are index funds their expense ratios, on average, are lower than traditional mutual funds.

Another reason ETFs can sometimes offer lower expense ratios is that ETFs do not incur as many costs to maintain shareholder records, while mutual funds must keep and maintain records of each individual shareholder.

Commissions and sales loads

Unlike mutual funds, ETFs are bought and sold on the exchanges and typically there are charges associated with this service. These charges can be in the form of a flat transaction fee or a fee assessed on an investor's total account balance. Some mutual funds charge sales loads, which are similar to brokerage commissions in that they compensate the broker who sold the fund. A sales load is typically expressed as a percentage of fund assets.

Bid-ask spread

When buying or selling ETF shares on an exchange, there is a difference between the price a dealer is willing to pay for an ETF share (the "bid") and the somewhat higher price the dealer will accept to sell that ETF share (the "ask"). As a result, an investor will typically buy ETF shares for slightly over "market" price and sell for slightly less.

Bid-ask spreads are typically lower for ETFs that are heavily traded or that own securities that are highly liquid. Mutual fund shares do not incur bid-ask spread costs, as all trades are transacted at a fund's net asset value (NAV) at the end of the day.

Premium/discount volatility

ETF shares are designed to trade on an exchange at a market price that approximates the market value of the ETF's underlying assets. Typically, the market price of an ETF's shares is slightly higher (trading at a "premium" to) or lower (trading at a "discount" to) than the market value of the ETF's underlying assets.

Keep in mind that it is the change in premium or discount that affects an investor's returns, not the level of premiums and discounts—such as when an investor buys shares at a premium and later sells at a discount. There are no premiums or discounts associated with mutual fund shares, as they trade only at NAV, once a day.

ETF fundamentals