Investment fees for mutual funds vs. individual stocks

Factual Questions
1

I have some index funds with Vanguard and it’s nice and easy to buy and sell funds. It doesn’t cost me a fee to do so. (Am I paying for it through the expense ratio?)

Now, I’m interested in buying individual stocks, but it seems I would have to open a brokerage account with its attendant trading fees, like the kind I see advertised elsewhere like $7 a trade or something. Did I get that right? So every time I buy or sell something, I have to pay the brokerage? Do these stocks have expense ratios as well?

I think I’m missing something fundamental here about stocks and mutual funds. Please enlighten.

2

interested to hear…im actually going to rolling over a vanguard account…probably to a brokerage account

3

Mutual funds have an associated expense ratio because there’s a fund manager who is managing the portfolio of stocks associated with that fund. He buys and sells individual stocks to alter the fund’s portfolio from time to time; that’s why your annual 1099 form often shows short-term and long-term capital gains, even when you haven’t sold any shares of the overall fund. The expense ratio pays his salary. Index funds typically have low expense ratios because there’s not much for the fund manager to do; the fund’s portfolio is pretty tightly defined by the index it’s attempting to track.

Exchange-traded individual stocks don’t have an expense ratio because the only person making buy/sell decisions is you, the shareholder. Instead, every time you buy or sell shares of a stock, you pay a transaction fee to the brokerage who facilitates the transaction.

4

The expense ratio is a yearly “fee”, or more precisely an expense. You don’t see any charges on your account statement, your gain is decreased, or your loss increased, by this amount automatically, and “in the background.” The charge occurs continuously, every year you hold the account. And the actual dollar amount varies according to the dollar value of your account.

Yes, you have to pay a commission on every stock trade. This expense IS noted on your account statement. The PERCENTAGE cost to you is based on the total amount of your trade. If you buy $1000 of stock and your commission is $10, this represents a 1% charge on your trade. If you buy $10,000 of stock, that same commission is only a 0.1% charge on your trade. Buy you only pay a commission on the day you buy and the day you sell.

Just from a trading cost point of view for you, the explicit commission on stocks could very well be much less than the holding cost of a mutual fund (if you keep them for many years).

On the other hand, your performance will likely be much better sticking with a low-cost Vanguard Index fund. While I don’t believe the “Efficient Market Theory”, I also note that a preponderance of actively managed funds fail to beat the market average (that an index fund will give you) every year.

J.

5

Expense ratios paid to mutual funds/ETFs are different from commissions paid to brokerages.

Money owed from expense ratios is taken out of the amount of money you have invested in a fund. For example, imagine a fund with an expense ratio of 0.50 and $100k invested. Assume the fund was completely flat on the year - didn’t go up or down at all. With a 0.50 expense ratio, your account balance would be $99.5k (-$500) after a year.

Common individual stocks do not have expense ratios (I’m not including more exotic exchange traded products like MLPs and BDCs). You don’t have to pay the company to own their stock. As the name implies, expense ratios are there to pay the expenses of the mutual fund management company (salaries, research, etc.).

You’re correct about commissions being collected when trades are executed. Different brokerages charge different amounts for different trades. Many discount brokerages (Ameritrade, Etrade, etc.) offer commissions in the $5-$10 range for individual stock trades. Commissions charged for mutual funds can vary based on a few factors: the fund family (Vanguard, Schwab, Fidelity, Pimco…), your broker (Ameritrade, Etrade, Merril Lynch, Fidelity…) and your brokerage’s relationship to the fund family.

As an example, consider Charles Schwab:

Schwab both operates as a mutual fund manager and a broker for individual accounts. If you hold your 401k, IRA, brokerage account, etc. at Schwab, they have an interest in you buying their funds. Thus, they allow you trade their funds for free. However, they still make money off of you because you have to pay the expense ratio. If you have an account at Schwab and wish to buy a Vanguard mutual fund, Schwab is going to charge a commission fee on the trade since they won’t be making any money on your funds parked with Vanguard.

That’s the dumbed down version. As you can probably imagine, there are various business relationships that affect who charges who what commission based on XYZ factors.