Mutual Funds vs ETFs: Why Fees Are Costing You Thousands

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Mutual Funds vs ETFs: Why I Don't Let Mutual Fund Companies Buy Me Coffee

Today, we're going to be talking about mutual funds versus ETFs. Why should you care? You should care because I use this podcast to help you, my clients and my friends understand why Leanne manages money the way that she does.

In other words, why am I doing what I do with your money?

My No-Conflict Policy

If you spent any time in my office, you know that I do not like mutual funds and I use them as a last resort when I'm investing your money. But you may not know why. And so this episode may go deeper into that.

Another thing I want to point out before I actually dive in is that I don't even let a mutual fund buy me a cup of coffee because I don't want any conflicts of interest in my work. So when I say to you, "This is the best way to invest" or "This is what I think we should do," I want you to always know that that is actually in your best interest.

And it's not because a mutual fund company is providing my firm a kickback. Believe me when I tell you I have worked in firms where mutual fund companies were paying for our client events and providing a kickback to the firms, which is not good for you.

So with no further ado, let's dive in.

Mutual Funds: A Good Idea Gone Wrong

First, we have to understand that mutual funds were started in the 40s and they were started in the 40s actually as a really good and revolutionary idea, which allowed smaller investors to buy fractional shares of companies within the funds instead of having to buy what they call round lots of stocks—stock purchases where you buy 10 shares at a time.

So this kind of created a door open for people who didn't have tons and tons of money to begin to invest. So they were a great idea at the time.

Now, the problem with mutual funds is the fees. We're going to come straight out and say it. And the other problem with mutual funds is the lack of transparency about what companies you have fractional shares in.

Another problem with mutual funds are the commissions that are paid to the advisor who puts them in your account. So I don't like them, as you already know, but I want you to understand that's why they existed.

They allowed small investors to get started and they created pools of money that then allowed a fund to open up this large investment pool to smaller investors.

What Are ETFs?

Now, ETFs are something like a mutual fund in that they actually track the same index and track the same kind of companies as far as what's owned, but they actually trade like stocks. So ETF stands for exchange-traded fund.

And so ETFs and mutual funds kind of look the same when you look at them on a piece of paper, but they're completely different animals.

Like I just said, ETFs actually trade throughout all of the market hours in real-time prices, whereas mutual funds only post their valuation or the cost of their shares at the end of market close. And the next day when it opens, it sets up a day of trading at something called net asset value.

In other words, blah, blah, blah. What do you pay for one share?

Where the Rubber Meets the Road: Fees

OK, so where the rubber really meets the road is with the fees, because fees impact the performance of your investments, right?

The average ETF expense ratio—and expense ratio is nothing more than the cost of being in the investment, there's no way around it—so the average ETF expense ratio is 0.16%.

The average mutual fund ratio? Wait for it. The average mutual fund ratio is 0.68%. So it's four times higher.

So that's the average 0.68%. Believe me when I tell you I see mutual fund ratios come through my office on the pieces of papers from people's 401ks and other investment advisors that are closer to like 1% and 1.3%.

The Real Cost Over Time

So on $100,000 invested over 20 years, if you have that same $100,000 in an ETF versus a mutual fund, you will pay $27,000 to the mutual fund company just in the expense ratio.

But wait, there's more.

The Hidden Fee Nightmare

Mutual funds also have 12B1 marketing fees where you are literally paying for their advertising budget up to 1% of your assets. There are transaction costs. So every time the fund manager trades, yep, you pay the brokerage fees.

There's also what I called cash drag, where the funds have to hold on to cash for redemptions and is earning zero while the market is on the rise. There are also load fees. So a lot of mutual funds charge 3% to 5% just to buy in either on the front end or the back end.

And most of the time, those loads go to the advisor as a commission. And then, of course, let's not forget account maintenance fees. Oh, my word.

Tax Inefficiency: The Final Insult

And then there's tax inefficiency with mutual funds. They will generate a taxable event when the managers trade. So you can end up owing taxes even if the fund lost money. ETFs are structured to minimize taxable distribution.

The Real-World Example That Will Shock You

So in the real world, let's say you invested $50,000 in the S&P 500 mutual fund with a 0.75% expense ratio versus an S&P 500 ETF with a 0.03% ratio. Both track the same index. But at the end of 25 years, the mutual fund costs you $47,000 in fees alone.

The Bottom Line

This, my friends, is why I don't put mutual funds in your investments. You're welcome.

When you can get the exact same market exposure through an ETF for a fraction of the cost, with better tax efficiency, and without all the hidden fees, why would you ever choose a mutual fund? The only winners with mutual funds are the fund companies and the advisors getting paid commissions—not you.