One of the basic tenets of investing is "Don't pay more in fees than necessary." You can't control whether you'll make a profit or loss on any investment, but you can control what you pay to acquire and hold the investment.
Fees and profits
Fees are fairly consistent, in the sense that they consistently eat into your profits (also known as your return on investment, or ROI). This is one area where investors should focus a lot of their attention. But the sad fact is that many investors never consider fees when evaluating an investment.
Lower fees should be one of your top priorities in any investment product. Smaller fees equal more money in your pocket. Sometimes you need to pay more for a higher level of service, but not in index-based products.
In a mutual fund's prospectus, after the load disclosure is a section called "Annual Fund Operating Expenses." This is better known as the expense ratio. It's the percentage of assets paid to run the fund. Many costs are included in the expense ratio, but typically only 3 are broken out: the management fee, the 12b-1 distribution fee, and other expenses. And, it's not that easy to find out what fees are contained in the "other expenses" category. The size of the expense ratio determines how much money the investor ends up with.
Why ETFs may have lower fees
ETFs avoid many of these fees because the fund usually doesn't buy or sell the stock held in its portfolio. This may sound strange: The fund holds stock but doesn't buy stock. That's the secret. By not buying stock, the ETF avoids all kinds of charges. It puts the burden on the people or firms causing the trades. It does this through a unique device called the creation unit.
The fund manager provides a list of securities each day that it will accept in exchange for newly issued shares of the ETF. For index funds, these shares are typically identical in number and weights to what the individual names constitute of the index the fund is seeking to track. For ETFs, the portfolio manager is likely setting creation baskets in a way that deviates from the benchmark to get more exposure to names they currently favor and less (or no) exposure to names they would like to underweight.
Redemptions work in a similar fashion. If an Authorized Participant (AP) wants to redeem shares (sellers want out of the fund) the ETF manager publishes a list of securities (and weights) the AP can expect to get back if they redeem shares of the ETF.
There are a few other factors that help reduce expense ratios for ETFs, like no 12b-1 fees; for index ETFs, due to their innate structure, the fund portfolio remains static.
By creating a way for the ETF to hold stocks without buying stocks, it doesn't have to pay brokerage commissions or any other transaction costs—that's a major area of cost savings outside of the expense ratio. The buying and selling costs, the brokerage costs, and the transfer agency costs associated with buying the portfolio stocks and transferring them to the ETF are all borne by the AP. The AP even pays the fund's custodian a fee to receive the shares into the fund and another to deliver the shares out of the fund. That's because the AP, not the fund, is responsible for gathering the stocks for the creation unit and for taking them back upon redemption.
As always, there are exceptions. Non-equity ETFs composed of alternative assets such as commodities are composed differently and have different holding structures and different associated costs.
Fees are important to evaluate as part of any investment purchase you make. Lower fees could mean more money in your pocket.
