When people talk ETF fee wars, they tend to talk about Schwab, Vanguard and iShares battling it out over who has the lowest-cost emerging markets ETF.
This mattered a lot a few years ago, when providers were charging crazy-high prices for simple beta exposure. But today, we’re talking pennies. When I can buy a diversified portfolio of ETFs with a blended expense ratio of 0.0865 percent per year , the battle for low-cost core exposure has reached the point of diminishing returns.
That’s not to say, however, that the ETF fee war is over. Far from it. I expect it to rage hotter than ever in 2013, as it spreads from the battle over core exposure into other areas of the market.
Here are three hot spots I’m monitoring in the year to come.
1) IAU vs. GLD
Gold is a commodity. By definition, two ETFs that hold gold bullion should deliver identical performance. Therefore, if you’re choosing a gold ETF, you should choose the one with the lowest all-in costs.
iShares was late to the gold ETF party. Its gold bullion ETF—the iShares Gold Trust (IAU)—launched on Jan. 21, 2005, a little more than two months after SSgA launched the SPDR Gold Shares (GLD) on Nov. 18, 2004.
The two funds charged the exact same expense ratio and do the exact same thing, holding gold bullion in a vault. But with first-mover advantage (and a friendlier ticker), GLD gathered almost all the assets. By June 30, 2010, GLD had $52.8 billion in assets, while IAU had just $3.4 billion.
But on July 2 of that year, iShares slashed the fee on IAU from 0.40 percent to 0.25 percent, undercutting GLD’s expense ratio by nearly 40 percent. Since then, IAU has dominated GLD on a net flows basis:
- IAU:$6.8 billion in net inflows
- GLD:$2.8 billion in net inflows
You have to be very careful looking at those numbers. I’m not implying a one-for-one switch here. Instead, what’s happening is that IAU and GLD are dividing the market.
With its lower expense ratio, IAU is attracting financial advisors and retail investors who care a great deal about the “all-in fee” of their portfolios.
But GLD retains an important advantage over IAU for some investors. Both products trade at an average spread of $0.01/share. But because GLD has a larger share price—one share of GLD costs $163.09, while one share of IAU costs just $16.39—GLD is cheaper to trade on a percentage basis.
That goes double for institutional investors:Unlike retail investors, who might pay $9.99 for a trade of any size, institutions often pay commissions on a “pennies-per-share” model. Fewer shares = lower commissions, making GLD even cheaper for them.
Thanks to these trading efficiencies, GLD attracts the bulk of institutional and “hot” money. At the same time, IAU’s low price clearly appeals to the advisor community and those who are buying for the long haul.
What will happen here?
A divided market.
I bet IAU’s assets will continue to grow faster than GLD, as it becomes the fund of choice for retail investors and advisors. GLD will remain the behemoth, however, by appealing to institutions and the trading community.
It’s a split I expect to see more of:Low-cost products that resonate with the advisor community and higher-cost products designed for traders and institutions.
2) EEM vs. IEMG
I think the most exciting fee war—the place where investors stand to gain the most by making a move—is between the iShares MSCI Emerging Markets Index Fund (EEM) and the iShares Core Emerging Markets ETF (IEMG).
It may seem strange to have a fee war within a single company, but iShares was forced into it and has handled it well.
iShares’ $50 billion flagship emerging markets product, EEM, had been losing ground to lower-cost rivals for years. Rather than cut its fee ( around 0.66 percent ) and sacrifice millions in profits, iShares introduced a lower-cost version charging just 0.18 percent per year, or $18 for each $10,000 invested.
That’s cool, but here’s the kicker:The new fund also offers better exposure than EEM.
Many investors overlook the fact that EEM excludes small-cap stocks; it is the Russell 1000 of the emerging markets world. IEMG holds all the same stocks as EEM, plus small-caps:Think of it as the Russell 3000.
Given a choice, I’m guessing investors want fuller exposure. Small-caps are the most dynamic corner of the emerging markets space, and investors should want them in their portfolios.
What’s odd is that, since the launch of IEMG on Oct. 18, 2012, EEM has crushed it in asset gathering, pulling in $11.8 billion, while IEMG gained just $290 million.
Part of that is driven by Vanguard’s decision to change the benchmark on the Vanguard FTSE Emerging Markets ETF (VWO). Previously, VWO tracked the same MSCI index as EEM. As it shifts from MSCI to a FTSE index, investors benchmarked to the MSCI index seem to be moving to EEM to maintain consistent exposure.
But the ultra-low numbers for IEMG surprise me. The fund is much, much cheaper than EEM, and it trades fairly well. Long-term investors and advisors who don’t worry about benchmarking risk should buy it in droves.
I think that will happen this year. I think, by the end of the year, IEMG will be a $1 billion product, on its way to $10 billion. If it doesn’t, it will say something very important about the market.
3) PowerShares vs. … PowerShares?
Some of the most interesting fee cuts of the past few years were made by a firm not known for its low expenses:PowerShares.
Since its founding, PowerShares has promoted its products as better-than-indexes. Sure, its charged high fees—0.75 percent for its original flagship equity products—but they promised performance that would justify the cost.
But in recent years, PowerShares has come to market with low-fee offerings like the hugely successful PowerShares S'P 500 Low Volatility Portfolio (SPLV), which charges just 0.25 percent in annual fees. SPLV has been a huge hit for PowerShares, pulling in $3.2 billion in assets since its launch in May 2011; for many, it has become a core holding. The old PowerShares might have priced this market-beating index at 0.75 percent. But the company has learned:If you want to be a core holding, you have to be low cost.
We’ve seen a similar thing happen with PowerShares’ suite of fundamentally weighted FTSE RAFI ETFs. The firm slashed fees on the domestic FTSE RAFI products in 2008, and last year, yanked down fees for the international versions from 0.75 percent and 0.80 perceent to 0.45 percent and 0.49 percent, respectively.
It lowered fees on the PowerShares S'P 500 High Quality Portfolio (SPHQ) from 0.50 percent to 0.29 percent last year as well.
PowerShares’ message to the rest of the industry is telling:Strategy indexes work— you can sell performance in the ETF space. But if you want to do that, you have to price things at a reasonable level.
That’s why I think the fee wars are only getting started.
The ETF industry has learned that fees matter to advisors. If you want to be at the core of investor portfolios, you have to be priced low enough that an advisor’s all-in fee (including fund fees) stays in the 1 to 1.5 percent range, or lower. When a fund costs 0.75 percent, it’s tough for advisors to charge enough to make a living.
Areas of the ETF market remain where fees are still stubbornly high:commodities in particular, where issuers seem to think 0.75 percent is the bare minimum you can charge.
They get away with it, I think, because there are vast differences between competing commodity ETFs, and the choice of which ETF you buy matters more than saving a few basis points.
But there will come a day when an issuer offers a good commodities strategy at 0.40 percent. And when they do, I think they’ll get asset flows.
There are other areas too. The big country funds cost too much. Currency products are pricey. Liquid alternatives cost big. And sponsors of active funds—PIMCO aside—need to realize that charging relatively high fees means hurdles of outperformance is that much higher.
Mark those down for the fee war to watch in 2013. In the core beta space, we’re reaching the end.
But everywhere else? We’re just getting started.
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