Alligators live in the sewers of New York City. Elvis is alive. Twinkies have an infinite shelf life. Popular urban legends one and all! There are also popular urban legends about exchange-traded funds (ETFs).

The media gets a lot right on ETFs: ETFs are structured similarly to mutual funds, they trade similarly to stocks, they’re low-cost (and getting lower), and offer quick diversification. However, other reports miss the mark. There may be a little nugget of truth but also a broader story to explore. Let’s break down a few of these ETF urban legends.

ETFs cost less than mutual funds

Okay, I know I just said that I agree with the assertion that ETFs are low-cost, but I disagree with the “why.” The asset-weighted average mutual fund expense ratio is 0.69%, while the average ETF expense ratio is 0.29%.* Many articles imply or directly state that by virtue of being an ETF, the product is cheaper. However, it’s not the ETF “wrapper” that makes the investment low-cost; it’s the way it’s managed.

ETFs are less expensive because they’re mostly index trackers (about 91% of ETFs are index–based, as you can see in the chart). This is also the reason why no-load index mutual funds are inexpensive. In contrast, actively managed funds, which make up more than 90% of all mutual funds, attempt to outperform the market and carry higher expense ratios (asset-weighted average of 0.80%).* This results in mutual funds (but really it’s active funds) having a higher expense ratio than ETFs.

ISGCETF_Chart

ETFs are a homogeneous bunch

I’m always a little amused when I hear broad statements about ETFs as if they’re a uniform group of investments. In reality, there are more than 1,500 ETFs trading in the United States, with many different investment strategies and structures. When I look at the list of the largest ETFs, I see a wide variety. There are broad U.S. stock funds tracking indexes such as the S&P 500 right next to emerging-markets equity funds holding securities from over 20 countries such as China, Brazil, and South Africa.

There are large total-market bond funds that invest in thousands of investment-grade bonds across all sectors and maturities and other funds investing exclusively in real estate investment trusts. There’s also an ETF holding a single asset: gold bars held in a vault in London. So, as you can see from just a sampling of very popular products, ETFs can be as eclectic as Elvis’s ’70s era jumpsuits!

Stay tuned for more ETF urban legends in the coming weeks. In the meantime, Elvis and I are off to New York City, with Twinkies in tow, to track down those alligators!

* Source: Vanguard research paper: Choosing between ETFs and mutual funds: Strategy, then structure., September 2015.

 

I would like to thank my colleague Tim Thornton for his contributions to this blog.

Notes:

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including the loss of the money you invest.