ETFs, Mutual Funds and Fee Questions

The cheapskate mutual fund investor looks carefully at fees to make sure they match the value received. Some investors, in search of the best possible bargain, look to exchange-traded funds (ETFs) because they have a reputation for being so cheap. ETFs are not always the cheaper course, though. It all depends on the structure of the funds being compared and the value of those fees.  

ETFs are set up as baskets of stocks held in trust. The fund manager buys the securities, then lists certificates on the market equal to the underlying value. These certificates trade in real time; investors looking to cash out either sell their certificates at any hour of the day or ask the fund manager for their share of the shares. Individual investors rarely ask for the stock, but large institutions do. This keeps the value of the certificates in line with market value; otherwise, an institution could buy an ETF trading at a lower value than the underlying index, demand the shares from the basket of securities and then sell the securities on the open market to lock in an easy, risk-free profit. 

A mutual fund, by contrast, prices its securities only once a day. Trades happen only at the end of the day, and they always involve cash. If there are more redemptions than new investments, the fund sells some of its securities, which might trigger a capital gain. ETFs, instead, usually settle redemptions with securities, with no tax effect. However, ETFs sometimes have to sell securities. Effective Oct. 5, 2007, Standard & Poor's deleted Archstone-Smith (NYSE: ASN), a real estate investment trust that is being acquired, from the S&P 500 Index and replaced it with Noble Energy (NYSE: NBL). That means that everyone running an S&P portfolio had to sell Archstone-Smith and buy Noble Energy. The capital gain was passed on to investors, who have the fun of settling up with the IRS. 

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