The iShares Empire Strikes Back ... With Low Fee Funds

Seeking Alpha

By Morningstar:

By Paul Justice

This week BlackRock launched a "Core" series of ETFs, which is really a branding scheme around six existing funds and four new launches. If you’ve been watching the financial news channels or stuck around after the presidential debates, you’ve probably already seen the commercials. The firm is pitching 10 funds as core building blocks aimed at long-term-minded investors. We wholeheartedly agree with their pitch: All 10 are low-cost, effective tools with which investors can build an effective and balanced portfolio. These funds possess all the aspects we like about ETFs when used by investors over the long haul.

What We Really Like

It’s hard to come up with criticisms for a fund company that is already a low-cost provider when it decides to cut fees even further, but the nature of this program has so many interesting angles that we’d be remiss not to try and figure out why they chose this route. Let’s start with what we really like: the fee cuts to six large, existing funds. Though these funds will have modified names going forward, both existing and new investors will find much to like about these funds.

  • IShares S&P 1500 Index ISI became iShares Core S&P Total US Stock Market ETF (ITOT - News) and saw its expense ratio drop to 0.07% from 0.20%.
  • IShares S&P 500 Index (IVV - News) became iShares Core S&P 500 ETF and saw its expense ratio fall to 0.07% from 0.09%.
  • IShares S&P MidCap 400 Index (IJH - News) became iShares Core S&P Mid-Cap ETF and saw its expense ratio drop to 0.15% from 0.21%.
  • IShares S&P SmallCap 600 Index (IJR - News) became iShares Core S&P Small-Cap ETF and saw its price fall to 0.16% from 0.20%.
  • IShares Barclays Aggregate Bond (AGG - News) became iShares Core Total US Bond Market ETF and saw its expense ratio drop to 0.08% from 0.22%.
  • IShares 10+ Year Government/Credit Bond Fund GLJ became iShares Core Long-Term US Bond ETF (ILTB - News) and saw its expense ratio fall to 0.12% from 0.20%.

We love to cheer about fee cuts to large funds because it benefits all investors directly. For example, the 0.14% lower fee in AGG alone will save investors $22 million per year, assuming the fund’s assets stay at $15 billion. BlackRock and iShares will also likely see this fund grow because it is now more competitively priced versus its peers, meaning that investors in aggregate will likely save even more, and iShares may be able to retain its profitability in the fund. The fund provider suffers some forgone revenue today in the hopes it will grow in the future, demonstrating a great virtuous cycle in the capitalistic model.

What We Kind of Like

There are two aspects of this “Core” series of funds that we think are good, but they’re not game-changers for investors or BlackRock. First, the name changes. We like the idea of delivering a simple, clear message to investors that allows them to sort through the maze of fund options available today. Identifying 10 funds that should be used as the basis for an asset-allocation strategy seems like a logical step in that direction, especially for a firm with nearly 300 ETFs available in the U.S. alone. With the word “Core” prominently displayed in the name, investors now know which funds they should look at first if they are considering the iShares lineup.

We also kind of like the four new ETFs. They are all among the lowest-cost options available to investors in their respective categories. They are also extremely well diversified representations of market segments most investors would want to include in their portfolios.

  • iShares Core MSCI Total International Stock ETF (IXUS - News) (0.16%)
  • iShares Core MSCI Emerging Markets ETF (IEMG - News) (0.18%)
  • iShares Core MSCI EAFE ETF (IEFA - News) (0.14%)
  • iShares Core Short-Term U.S. Bond ETF (ISTB - News) (0.12%)

The Wrinkle

Again, it’s difficult for anyone to criticize iShares for launching low-cost and well-constructed funds. We’d love every provider to do the same. We also think these four new funds are properly identified as potential core holdings, when used in the proper proportions, for the vast majority of investors.

The curious part is that these four funds are extremely similar to several existing ETFs on the market, most notably to four that iShares already issues. By looking at the names, most investors would have difficulty distinguishing these new offerings from the other funds, save the “Core” identifier in the new funds. Here are the existing funds:

  • iShares MSCI ACWI ex US Index (ACWX - News) (0.34%)
  • iShares MSCI Emerging Markets Index (EEM - News) (0.67%)
  • iShares MSCI EAFE Index (EFA - News) (0.34%)
  • iShares Barclays 1-3 Year Treasury Bond (SHY - News) (0.15%)

For the most part, the new funds are actually better for long-term investors in two ways. The new funds track modified versions of the existing indexes, and they typically purchase more securities than the existing funds. The “core” funds will track the Investable Market Indexes from MSCI for each market segment, which will result in more holdings, more diversification, and will provide exposure to more mid- and small-cap stocks than the EAFE, Emerging Markets, and ACWI ex U.S. standard indexes provide. For example, the IMI emerging-markets index tracks more than 2,600 stocks in a single fund while the old emerging-markets index follows just over 800 securities.

While these are real differences, the performance of the new funds will likely be extremely similar to that of the existing funds, except for periods when there is a large divide between the performance of small and large-cap stocks. We would expect these events to be fairly rare.

A simpler solution, from an investor standpoint, would have been for iShares to simply cut the fees on their existing funds to match the competitive landscape, so many people are asking why the firm didn’t take this route. The answer, in our view, is profits.

BlackRock is in the precarious position of serving two masters. First, it’s a publicly traded company whose shareholders are rightfully demanding that the company generate the best earnings it can over the long haul. Slashing fees on those four existing products would have a material impact on earnings both today and likely over the long haul. If we assume that asset levels were to stay the same, dropping the fees on these funds, which have more than $85 billion invested today, would have resulted in an annual loss of revenue and earnings of more than $260 million per year. While owners of the existing ETFs would love to see that move, that’s not a decision that shareholders in BlackRock would applaud.

Neither have shareholders been applauding the lagging growth in these four funds over the past few years. Incremental dollars invested have been going to competitors' funds, with the notable growth of Vanguard Emerging Markets (VWO - News), which has been especially popular with buy-and-hold investors.

Dealing With Seemingly Irrational Competition

Normally, fund investors have little reason to read an earnings transcript from a publicly traded fund issuer, but those curious about this decision by BlackRock will find this transcript particularly interesting. Starting on page 11, President Robert Kapito outlines the strategy of this initiative and provides some telling insights on how iShares will deal with three competing issues: They want to improve their competitive position with buy-and-hold investors, maintain the liquidity advantage of their existing funds over competitors, and finally grow earnings for shareholders as a result.

Mutually owned competitors like Vanguard don’t have to worry about the third issue, and that’s why they don’t have to tailor their funds to different types of investors. Vanguard will likely stick to fee cuts going forward for two reasons: First, they have always targeted buy-and-hold investors rather than higher-frequency traders, and their fees only serve to cover the costs of operating the funds. Management is serving as steward only to the fund investors rather than balancing the competing interests of shareholders as well.

The new funds allow iShares to compete very effectively in the “buy-and-hold” market, but this decision may alienate some existing clients. If I were an owner of any of the legacy iShares funds (full disclosure, I do own some), and I have an unrealized gain in that position, I’d be irked that I cannot participate in the lower-cost option because of my tax situation. A fee cut would have left my choices clearer, tax situation simpler, and raised my opinion of iShares as a steward of my capital.

Flipping Share Class Structures Upside Down

We’ve noted several times how ETFs are changing the way funds companies do business. Perhaps the oddest part of this “Core” series launch is the way the fees are targeted. Historically, open-end fund companies have created an alphabet soup of share classes that give different investor types access to the same fund but at different fee levels. In almost all cases, the Institutional share classes are the most exclusive and charge the lowest fees.

While these new funds are not separate share classes of the existing ETFs, they are the closest resemblance we’ve seen. Interestingly, the “buy-and-hold” shares, which many will argue are targeted at retail investors, are considerably less expensive. This is just another example of how the growing ETF landscape is flipping fund distribution on its head.

Will this targeted strategy work? We’ll see, but it’s an uphill battle. IShares has arguably the best investor outreach and a strong reputation with many advisor and third-party manager segments. It’s clear that iShares will be putting its vast resources behind this initiative, so I’m inclined to believe that these funds will attract assets in short order, and much of it will not be coming from other existing iShares funds. Many investors that would have otherwise chosen low-cost options from Vanguard could find these attractive, especially if they are fond of benchmarks provided by MSCI. The pending index changes at Vanguard will lead to some turnover and tracking inefficiencies in the short term, so those investors looking to invest the next incremental dollar may pause before delving into those funds. In those cases, I wouldn’t be surprised to see these new funds from iShares turning up as a logical alternative.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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