There has been a lot of press recently about the cost advantages of bond ETFs vs. bond mutual funds. It might therefore come as a surprise that for many investors, bond mutual funds are actually the less expensive option. To understand why, let’s compare each of the costs you encounter when investing in bond mutual funds and ETFs.
Annual Expense Ratio
Bond ETFs are cited as being less expensive because they have lower expense ratios on average than bond mutual funds. The expense ratio is the money charged to investors to compensate the ETF manager or mutual fund company. While reported on an annualized basis, the fee is charged and deducted from the fund’s NAV on a daily basis. It is important to understand that this is a fee that is charged continually as long as the fund is held.
The average bond ETF has an annual expense ratio of 0.28%, according to Morningstar, while the average bond mutual fund has an annual expense ratio of 1.01%. If you are investing $100,000, the average bond mutual fund costs you $620 more per year than the average bond ETF. This is a significant amount of money not only in terms of the $620 per year, but also in terms of the loss of interest compounding on that money for long-term investors.
What About Bond Index Mutual Funds?
Most ETFs are passively managed, meaning they are designed to track an index, and there is very little discretion involved in the management of the ETF’s portfolio. Most bond mutual funds, on the other hand, are actively managed, and therefore employ a team of high-priced portfolio managers and analysts. Their goal is to outperform an index through smart investment picks.
However, not all bond mutual funds are actively managed, so a fairer comparison is passively managed bond mutual funds (called index funds). Bond ETFs win here as well, as the average expense ratio for a bond index mutual fund is 0.37%. This is almost two-thirds less than the average bond mutual fund, but still a third more than the average bond ETF.
Commissions and Sales/Load Fees
When you factor in commissions, the question of whether bond ETFs or bond mutual funds are more expensive gets more complicated.
When you buy and sell most bond ETFs, you are charged a commission, which is the same as the commission for buying and selling stocks. This is in the range of $8 to $10 each time you buy or sell with the major online brokers. If you are transacting through a full-service broker, the fee can range from $50 to $100 — or sometimes more.
This can be a big cost to investors who are investing small amounts of money on a regular basis. Take an investor who is following a monthly investment plan, where they buy $1,000 worth of bond ETFs each month. Even if the investor is investing through a discount broker, they are going to be paying a $8 commission on the low end. While $8 does not seem like a lot of money, as a percentage of a $1,000 investment, it is fairly high. If you are investing in $1,000 increments, this equates to an extra 0.8% in fees. At $5,000, the fee equates to an additional 0.4%. While this is a one-time non-recurring fee, there also is a commission charged when you sell the position.
Mutual funds also can have commissions and transaction charges, and even worse, load charges (you can learn more about this in our article on understanding and minimizing mutual fund fees). However, with most mutual funds you also can buy the fund directly from the mutual fund company, bypassing your stockbroker, and without paying a load or a commission. If you are investing in increments of less than $5,000 and willing to have your funds located outside of your brokerage account, this option generally makes bond mutual funds the less expensive option.
If you are investing more than $10,000 at a time or only make one or two deposits/withdrawals into an ETF per year, then bond ETFs are likely to be the less expensive option. If you are investing smaller amounts of money on a regular basis, then make sure you factor in commissions when calculating ETF costs. If you are on a regular monthly investment plan, we suggest having an account directly with the mutual fund company as the most cost effective choice.
For more on bond mutual funds and ETFs, see the bond funds section at Learn Bonds.