Sector ETF expense ratios falling

Expense ratios for exchange-traded sector funds have dropped as much as 26% this year as industry expansion and competition drive down cost.

Barclays Global Investors, San Francisco, with $207 billion in ETF assets under management as of May 5, entered the price fray earlier this month. The firm cut expense ratios on 25 iShares sector funds to 48 basis points from up to 65 basis points.

State Street Global Advisors, Boston — with $83.7 billion in ETF assets under management as of April 28 — has gradually reduced annual expenses. As assets rise, SSg A will lower fees on its nine Select Sector SPDRs. The fees are 24 and 25 basis points, down roughly 60% from 65 basis points since the funds' 1998 inception.

Last year, Vanguard Group, Valley Forge, Pa., which had $16 billion in ETF assets under management as of April 30, lowered its fees on all but one of its 11 sector VIPERs, to 26 basis points from 28 in March 2005. Its real estate investment trust VIPER carries an expense ratio of 12 basis points, 6 basis points lower than when it was introduced in fall of 2004, said Noel Archard, principal, Vanguard Financial Advisor Services group.

Vanguard's VIPERs are a share class of Vanguard index funds

The price cuts come at a time when the ETF marketplace is booming, thanks to an increasing menu of ETFs, an increased retail presence through advisers, and increased use by institutional investors for functions such as transition management and cash equitization.

The ETF market is expected to grow 29% annually until it exceeds $1 trillion by 2010, according to Financial Research Corp., Boston.

And BGI and SSgA have a combined 85% ETF market share, according to FRC; the Bank of New York Co., which doesn't offer sector ETFs, comes in third with a 10% stake. Vanguard has a 4% share, while PowerShares Capital Management, LLC, Wheaton, Ill., has 1% of the market, FRC said.

Sector ETFs account for only a small piece of the ETF market, about $35 billion vs. more than $300 billion for all ETFs, market research shows.

Net inflows in sector iShares totaled $1.1 billion for the three months ended March 31, according to a monthly report from BGI. SSgA's Sector SPDRs took in $2.3 billion during the same time. Vanguard saw $1 billion in net sector fund inflows, while PowerShares gained $1.2 billion in sector fund assets, the report found.

Part of the appeal of ETFs is their reputation for being a cheap investment vehicle, said Dan Dolan, director of wealth management strategies for the $15.9 billion Select Sector SPDRs Trust, distributed by ALPS Distributors Inc., Long Island City, N.Y.

"The good ETFs have the ability to appeal" to both retail and institutional investors, he said. "Low expenses are an important ingredient if you're going to do that crossover,"

Expense ratios — and reasons for lowering them — can vary. The usual reason is asset growth and associated economies of scale.

However, several industry observers said BGI's latest adjustments were motivated by plans to introduce enhanced ETFs, which do not follow an index as closely as passive ETFs.

If BGI were to roll out enhanced ETFs, the firm would compete with offerings from PowerShares Capital that are priced at 60 basis points. Because enhanced strategies are typically more expensive, BGI needed to lower expense ratios for the passive strategies.

"We are very cognizant and aware of prices in the marketplace for different types of vehicles, but we don't evaluate ourselves alongside" other firms, said Bruce Bond, PowerShares president.

PowerShares has about 20 industry enhanced ETFs with $2.5 billion in assets under management as of May 11 that are comparable to the sector offerings from BGI and SSgA.

Some analysts view BGI's cuts as an attempt to attract more attention to its sector iShares, which invest in market segments such as technology, health care and consumer staples. It's the one area within the ETF market in which BGI isn't No. 1: Assets in State Street's Sector SPDRs were $19.5 billion as of March 31, compared with $13.5 billion for BGI, according to FRC.

Neither BGI nor SSgA discloses ETF revenues.

Regardless of market share, pricing disparities exist across the industry. BGI's 25 sector iShares cost nearly twice as much as the sector funds offered by SSgA and Vanguard. Yet each fund delivers the same amount of exposure to the market.

The Energy Select Sector SPDR, iShares Dow Jones U.S. Energy Sector Index Fund and Vanguard Energy VIPER have similar exposure to similar stocks.

"If the funds are delivering similar exposure, why pay twice as much?" Mr. Dolan asked.

BGI's sector iShares invest in a broader universe of stocks than the sector SPDRs, said Lee Kranefuss, chief executive officer of BGI's intermediary and ETF business.

"Different indexes require a different level of work to manage them," he said. "We try to price for the long term. … We are pleased with the asset gathering of sector funds," he said.

Generally, the complexity of the underlying index drives pricing, as increased turnover and volatility will be factored into the cost, executives at all of the firms said. Sales and service also are factors, they said.

That support is a big part of iShares' charm, Mr. Kranefuss said. BGI operates a call center, provides research and educational programs, and a dedicated website with various online iShares tools.

Most of BGI's sector iShares follow Dow Jones indexes, while Select Sector SPDRs divide the Standard & Poor's 500 stock index into nine sector ETFs.

"We're always looking at what is going on in the marketplace," said James Ross, co-head of SSgA's adviser strategies group. "We'll work to come up with the costs of infrastructure and market demands of the product, and apply an expense ratio that meets both of those needs."

Outside of sector ETFs, the pricing differences can also be seen in domestic index funds.

Overall, BGI is setting the industry pace, receiving eight of every 10 ETF dollars in 2005, Mr. Kranefuss said. That's because BGI "very astutely locked up all the major branded indexes as far as ETFs were concerned," said Gary Gastineau, principal of ETF Consultants LLC, Summit, N.J.