S&P’s Rosenbluth: ETF Fee War Is Good

Olly Ludwig
November 8, 2012


The widening “fee war” among ETF sponsors definitely benefits investors, Todd Rosenbluth, an ETF analyst with S'P Capital IQ, recently told IndexUniverse.com Managing Editor Olly Ludwig.

While the fee battle is emblematic of an exchange-traded fund industry that is beginning to mature, the competition among ETF sponsors should be more of a worry to mutual fund companies, Rosenbluth said. That’s because the shift to ETFs from mutual funds is in full bloom, and fund companies at the center of the ETF price battle—Vanguard, Schwab and iShares—will all discover that they’ll each garner healthy flows into their products in the coming years.


Ludwig:What is your take of what has been characterized as a fee war in the ETF space?

Rosenbluth: What we’ve seen over the last few years is that ETF asset growth is continuing, but at a slower pace. And what we think is happening, and what we expect to continue happening, is that the larger ETF providers are going to try to differentiate themselves on various factors. The expense ratio is still a key decision-making tool for investors. So, what Vanguard, iShares and Schwab are doing is trying to keep their costs as low as possible and appeal to a broader universe of ETF investors.

Ludwig: Let’s look at IVV, the iShares S'P 500 ETF (IVV) vs. the Vanguard S'P 500 ETF (VOO). The Vanguard fund is 5 basis points, the iShares is 7 basis points. Yes, Vanguard has bragging rights, but are a few basis points in expense ratio really significant in the grand scheme of things? If you project that over an investment lifetime, are those 2 basis points, absent all of the other cost variables, really worth fighting about?

Rosenbluth: The short answer is no. Investors may choose to go with one ETF family for all of their ETFs, or especially if they can get diversification. Vanguard gets to say they’re the cheapest, but if you’re working with iShares because you like the global equity portfolios that they have or you like the fixed-income portfolios they have, and you want S'P 500 exposure, you’re more likely, we think, to choose the iShares S'P 500 portfolio even if it is a basis point or two higher.

But as money continues to move into these ETF’s, we’re going to see the chances for ETF expenses to come down because this is, in part, a scale business.

Ludwig: When we talk about Vanguard and iShares, they’re traveling in the same traffic; more so now with the iShares launch of this “Core” product line. On the other hand, BlackRock is a publicly traded company and Vanguard is owned by its own fund holders. So Vanguard doesn’t want to acknowledge this as a fee war, but described it as a function of scale, as you were just touching upon a moment ago. What is your sense about that Vanguard claim? Is it credible?

Rosenbluth: Vanguard has always prided itself on being a low-cost provider trying to bring expense ratios down for its ETFs. Its most recent efforts to bring expenses down with a change in benchmark for many of the ETFs we’re talking about are in line with its broad mission. So I think they would be looking to bring costs down regardless of what iShares was doing.

iShares, in contrast, we think is likely responding to the fact that Vanguard has gained some market share from iShares in 2012…



Ludwig: … and in 2011, 2010 as well?

Rosenbluth: Yes, Vanguard has picked up some market share, but it’s still the No. 3 provider. iShares is still the leader in both the number of ETF’s and asset flows. From an investor perspective, we’re pleased that expenses are coming down and that iShares has also launched some ETFs to give people exposure to lower-cost offerings without changing the investment approach of some of their more popular funds.

Ludwig: We’ve been mostly talking about iShares and Vanguard so far, but with regard to Schwab, do you think they have the capacity to be a much bigger ETF provider if you fast-forward a number of years? Or will ETFs always be loss leader and a relatively small piece of Schwab’s business?

Rosenbluth: It’s true that Schwab still has a very small number of ETFs. But as they get assets moving into some of the diversified ETFs—both on equity as well as the fixed-income side—they’re more likely to launch newer ones. And then they have the chance to move into the upper echelon of ETF providers. And Schwab has picked up the low-cost approach, similar to Vanguard.

But as most people are aware, Charles Schwab is a broader financial services company, and can use ETFs as a way to get people in the door for all investments. Whether they’re tied to Charles Schwab or not, you can trade other ETFs on their platform. And once you get in the door at Schwab, they hope to keep you there.

Ludwig: So is it worth looking at Schwab differently in the context of this price war? They called a press conference and pretty much bragged about have the 15 lowest-priced ETFs, with their CEO Walt Bettinger on the call. And yet, as you say, its game is qualitatively different than it is for iShares and Vanguard because of the broad financial services shadow that it casts as opposed to Vanguard or Black Rock, which are more classic asset managers, right?

Rosenbluth: Right. Someone who is buying a Schwab ETF is likely buying it through their Schwab account and on the platform. The ETF part of the business is running independently from the financial services part of it, but there is some linkage and some benefits to that. For someone who’s looking for the cheapest ETF, Schwab has a number of them. But we would also say that they need to make sure they understand what’s inside the portfolios—whether it’s an ETF from Schwab or one from iShares or Vanguard—and make sure it fits with their investment approach. An S'P 500 index ETF is going to own what you think it owns. But if we’re talking about an ETF that’s tied to certain sectors, or certain investment styles, they’re not all run the same. And we think that that’s important too.



Ludwig: To that point, are there any grounds to be concerned that maybe the CRSP indexes Vanguard chose last month because they were cheaper might not be as straightforward and as sensible as, say, the MSCI indexes they are replacing, and could thus create exposure drift?

Rosenbluth: We would agree with that, both when the change initially happens with Vanguard moving to these new benchmarks and, less so, but on a go-forward basis, it may not be as easy to understand what’s inside a portfolio. Unless you do your homework, you’re flying blind.

But that would be the case regardless if it was tied to an MSCI benchmark or an S'P benchmark. Understanding what’s inside the portfolio is extremely important. But you can’t turn on CNBC or look in the Wall Street Journal and see how these CRSP benchmarks that Vanguard is going to be going with are doing. So you’re going to have to do the homework and make sure you understand what’s inside.

Ludwig: I wonder if you could take a step back and take measure of the ETF industry, which is approaching its 20-year anniversary. As you said earlier, assets continue to pour in. How do you view the entire phenomenon? Is it a zero-sum game with the mutual fund industry? And if so, is it going to become more pronounced, say, with 401(k)-related flows starting to kick in?

Rosenbluth: At S'P Capital IQ, we think ETFs are going to continue to gain market share over mutual funds. Not at the same pace that we’ve seen. But we think that that’s going to continue because they’re lower in cost and more transparent. They’re easier to invest in for both short- and long-term approaches. ETFs are also going to benefit as people move out of individual stocks and bonds and can get the diversification. So this isn’t just taking share from mutual funds, but from individual stocks as people get more comfortable with ETFs.

In particular, we’re going to see growth on the fixed-income side. This is still a smaller piece of the pie, relative to individual bonds or certainly relative to bond mutual funds. We think we’re going to continue to see gains, even if we do not see 401(k)s pick up ETFs. But 401(k) growth is probably going to happen down the road as well, which is why the initial conversation about fees is important.

Ludwig: When you look at the Morningstar mutual fund flows data versus the ETF flows data on the equities front, for example, you see outflows from equity mutual funds and, on the other hand, fairly significant inflows into equity ETFs. Is that like “Exhibit A” in the underlying shift in financial markets toward ETFs?

Rosenbluth: The argument is made that individual investors have been sitting out during the market rally that we’ve seen in 2012. That’s certainly the case for mutual fund investors. But the data that we’ve seen from Lipper and from other third-party groups show that money is, at the same time, moving into equity ETFs. Less money is moving into equity ETFs than is going out the door in mutual funds, but money is still coming in—and for all the reasons we talked about:lower costs, diversification, the chance to get exposure to sectors in industries. And all in an easy-to-use, tradable way.

So we think that that pace is going to continue as more people become aware and comfortable and understand the benefits of ETFs. But because what they’re buying is not always simple, they need to look under the hood and understand what those underlying securities are. Because just buying anything because it’s cheap could mean you’re getting ripped off.



Ludwig: What you’re saying is that there are two storylines here? One is that individual investors are sitting out as mutual fund outflows show; and the other is that investors are really liking what they’re seeing in the ETF wrapper in terms of cost structure and elastic sort of exposure alternatives? Which story is going to be more important over the long term? Or would they just kind of coexist and each has their own resonance?

Rosenbluth: I think they coexist. I think right now the reason we’re hearing the first story—that investors are moving out of equities mutual funds—is because there’s more money tied to mutual funds than ETFs. And so, net of mutual funds and ETFs, we see a negative in terms of flows in 2012, and in 2011 and maybe even 2010 as well. So that’s the dominant theme.

But I think as ETFs grow and they become a bigger piece of the pie and investors get more comfortable—and reporters get more comfortable looking at ETF data—we’re going to see that second story also be told.

Ludwig: A little bit more prominently over time, is what you’re saying?

Rosenbluth: Yes.

Ludwig: Now, as you look at this cost war, do you have any bone in your body that would prognosticate and share with me a sense of who you think might do better with what’s gone on here in the past few months that really suggests a ratcheting up of the competitive pressures?

Rosenbluth: Well, I actually think that everybody is going to win. That may sound like a noncommittal answer, but I think everyone is going to win because money is going to continue to move in. We think that Vanguard is still going to attract assets for its low costs, and we think that Schwab is going to grow.

And iShares has now added cheap ETFs to its lineup. And that’s in addition to the broadest lineup. They’ve got the most fixed-income exposure of all the ETF providers. And as investors get more comfortable using ETFs for that asset class, they’re going to grow and benefit as well.

So we think everyone is still going to win in the next couple of years. And then we’ll see if the ETF industry can jump the hurdle and continue to grow, or we’re going to see more of a slower pace because they can’t gain share from individual securities and mutual funds.


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