Exchange-traded funds (ETFs) are perceived as being cheaper than mutual funds. Investors asking whether this perception is confirmed by reality will find an unexpected and perhaps unsatisfying answer: it’s complicated. An analysis by Morningstar says that depending on the fund category, how the returns are calculated, whether or not Vanguard funds are included and ownership costs, ETFs are not always cheaper than mutual funds.

The analysis looked the data in a few different ways. First, it compared fees on an equal-weighted and an asset-weighted basis. Equal weighting is the traditional manner, where the average of the all of the funds within a category is calculated. Asset weighting, in contrast, places more emphasis on the expense ratios charged by the largest funds and less emphasis on the costs charged by the smallest funds. Morningstar then ran the comparisons excluding Vanguard funds. Vanguard was viewed as being unique because it is the only company to treat ETFs as a separate class of its mutual funds as opposed to a separate entity.

On an equal-weighted basis, ETFs are cheaper than mutual funds in all categories except for the long-term government bond category. Asset weighting favors mutual funds, however, with ETFs being the cheaper option only in the large blend, mid-growth and small blend domestic stock categories. When Vanguard funds are excluded, the advantage swings back in ETFs’ favor with only foreign large blend stock mutual funds being cheaper than their ETF counterparts on an asset-weighted basis. The differences reflect Vanguard’s role as the low-cost provider and the comparatively large share of mutual fund assets it controls.

Ownership costs include tax efficiency and trading costs. Stock-oriented ETFs, both domestic and international, are more tax-efficient than index mutual funds. Taxable-bond ETFs had the same tax-cost ratio as their mutual fund counterparts and lower potential capital gains, but had a higher frequency of distributing capital gains. It may be more difficult for bond ETFs to use in-kind redemptions, which is what makes stock ETFs more tax-efficient. Interacting directly with a mutual fund company eliminates commissions and might be preferable for regular deposits and withdrawals.

Source: “The Cost of Owning ETFs and Mutual Funds,” Alex Bryan and Michael Rawson, Morningstar Manager Research, December 1, 2014.

Related

Exchange-Traded Funds

An Inside Look at Exchange-Traded Funds

Feature

The Individual Investor’s Guide to Exchange-Traded Funds 2014

Exchange-Traded Funds

ETFs and ETNs: Knowing What You Own