A significant part of the appeal of ETFs is supposed to be their low fees. But not all ETFs are so cheap. Some ETFs, in fact, charge as much as actively managed traditional mutual funds — some even more than their traditional fund counterparts.
The average equity mutual fund expense ratio in 2014 was 0.70 percent; for bond funds it was 57 basis points, according to the Investment Company Institute 2015 Factbook. There's been downward pressure on traditional fund fees as a result of criticism and too much competition.
The average exchange-traded fund, for its part, charges 0.4 percent in annual fees, or 40 basis points. The granddaddy of such funds, State Street's SPDR S&P 500 (SPY (NYSE Arca: SPY)), charges a mere 0.09 percent, or 9 basis points.
Still, 429 ETFs charge as high an annual fee as the average traditional mutual fund fee of 70 basis points, according to Morningstar data. That's roughly 1 out of every 4 ETFs (or 24 percent of the 1,796 ETFs tracked by Morningstar). Then there are 396 ETFs that charge more than the traditional fund. And 47 ETFs that charge 99 basis points or more a year.
"The idea of paying upwards of 1 percent in expenses for an ETF is absurd," said Matt Hougan, the CEO of ETF.com. "It's a bad idea in a traditional mutual fund, and moving that into a quote-unquote 'efficient ETF wrapper' doesn't make it any better. Just say no."
Others disagreed — somewhat. With the big ETF players covering the easiest and most inexpensive indexes, more ETFs have been launched by niche managers focused on new slices of markets and sectors, as well as alternative investing and actively managed strategies.
Here's a look at some of the most expensive funds in several categories and the debate over whether they're worth the price.
The best reason to buy a high-fee ETF: when there's no other option even close to what it's investing in.
"It's justifiable to spend more if there are no alternatives in the space and if the trend makes sense," said Todd Rosenbluth, S&P Capital IQ's director of ETF and mutual fund research. He pointed to AdvisorShares' TrimTabs Float Shrink (TTFS (NYSE Arca: TTFS)) — which buys stocks based on outstanding shares, firm leverage and free cash flow trends — as an example of an ETF with high fees (99 basis points) that might nonetheless appeal to investors. TTFS does not have any close peers, he said, and combines a reasonable risk profile with strong returns. Over the past three years, the ETF is up 15 percent, versus an S&P 500 ETF total return of 12 percent.
On the other hand, AdvisorShares' Peritus High Yield (HYLD (NYSE Arca: HYLD)) fund is overpriced and underperforming, Rosenbluth said. "Spending 123 basis points on a fixed-income ETF is inappropriate," he said. "There are other, far cheaper options in the high-yield space, such as SPDR Barclays Capital High Yield ETF (JNK (NYSE Arca: JNK)), that also perform better. The average high-yield mutual fund has lower fees, in fact."
In the past three years, HYLD has returned negative 1.68 percent, while JNK is up by about the same percentage, with an expense ratio (0.40 percent) that is 83 basis points lower.
ETF.com's Hougan is more favorable on active funds in the bond space. "The market is fragmented and inefficient, and traditional indexes are poorly designed," he said, but he added that higher-fee active bond funds run into the same problem as active equity funds.
"The hurdle is too darn high," Hougan said. "Even if you believe the managers at a fund like HYLD can beat the market — and they've run into some real issues over the past year on the performance front — do you think they can beat the market by 1.18 percent per year?"
Hougan said it's hard enough to earn back a 1 percent expense ratio in the equity market, where you might expect an average 8 percent to 10 percent annual return during good times. But earning it back in the bond market when you expect 4 percent to 8 percent a year ... "That's tough!" he said.
Higher fees should be a hurdle investors have to jump high over, Hougan said. Hougan pointed to another AdvisorShares ETF, EquityPro (EPRO (NYSE Arca: EPRO)), and its 1.25 percent fee. "Beating the market at all is hard; beating it by more than 1.25 percent consistently is virtually impossible," he explained.
Over the past three years through Oct. 1, EPRO is up by 5.21 percent, versus a world stock category return of 5.09 percent, according to Morningstar. But it has beaten its benchmark, the MSCI ACWI ex-US Index, which is only up 2.31 percent in the past three years. And year-to-date, EPRO is down 2.6 percent, while the average world stock fund is down by more than 8 percent.
AdvisorShares CEO Noah Hamman said actively managed funds are prone to have higher fees but pointed to advantages they can offer. EPRO's managers made a tactical move to cash in the fall when they saw downward market momentum, for example, while HYLD has strong yield compared to peers, with a 30-day SEC yield of 11.52 percent. That compares to the Barclays High Yield Index 30-day SEC yield of 7 percent. Hamman said bond investors may value that more than total market returns.
"Active strategies have higher fees, but you're trying to add value," Hamman said, adding, "Ultimately, we see the ETF structure as a better way to deliver active management." Hamman cited intraday liquidity, the ability to use limit orders and daily transparency as ETF advantages, and noted they can also improve operational costs and tax efficiency over mutual funds.
He raises an important point: If the ETF is a better structure than the traditional fund, then maybe there is no need to compare its fees to traditional fund fees, because traditional funds simply don't need to exist anymore.
Another attribute common among pricey ETFs is that they're offered by smaller money managers. Since they are the ones getting into the less-exploited asset classes and strategies, they are also not achieving the economies of scale of a State Street SPDR ETF family or BlackRock's iShares, which can charge less based on massive asset bases, said Michael Rawson, ETF analyst at Morningstar.
Most investors using ETFs don't expect them to outperform indexes. Rather, they expect the index on which an ETF is based to do well, Rawson said. The most expensive ETFs, on the other hand, follow extremely specialized strategies, and should be used as such.
"While an ETF tracking the S&P 500 is a core portfolio building block, these high-cost niche ETFs are speculative holdings that investors might put a small portion of their portfolio into for a comparatively short period of time," Rawson said.
Higher-fee ETFs are ripe for fee pressure. Consider that even ETFs that aren't close to the highest fee in absolute terms are engaged in how-low-can-you-go battles. After Vanguard got into the ETF business, iShares launched its "Core" series of funds, offering basic index investments at a lower cost than it had done before.
Last month, Goldman Sachs launched a lineup of ETFs for the buzzy "smart beta" space, including a U.S. large-cap fund with an expense ratio of 0.09 percent — the same as the fee on the SPDR S&P 500. And that's versus an average smart-beta ETF expense ratio of 0.38 percent.
So if your ETF is charging even more than the average traditional mutual fund, or average index ETF, and it's not doing something wholly different from everybody else — or underperforming — think twice.
"People have the impression that all ETFs are low-cost, and that's not true," Rawson said. "Exotic strategies like these let investors get exposure they won't get anywhere else, so they make sense in that way. Just note that you're defeating the idea of low-cost passive investing."
—By Joe D'Allegro, special to CNBC.com
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