Price wars be damned. While a flurry of exchange-traded fund expense ratio reductions from several asset managers is positive across the board, institutional investors might be better served to look beyond the fee cuts, which tend to benefit retail investors and the asset managers themselves.
For example, according to FactSet, Fidelity Investments' MSCI sector ETFs have seen net flows of $113 million, or 3.6% of current assets, on 11 ETFs after expense ratio reductions on July 1. Fifteen BlackRock Inc. iShares core ETFs saw aggregate net flows of $3.2 billion, or 1.5% of current assets, for those ETFs after Oct. 5 expense ratio cuts. And Charles Schwab Corp., which sliced one basis point of annualized expense ratio from five ETFs on Oct. 7, saw net flows of $231 million, or 1.3% of current assets for those ETFs.
Dave Nadig, director of exchange-traded funds for FactSet, estimates BlackRock is willing to forgo $74 million in fees as a calculated bet that lower expense ratios will attract enough new assets to more than make up for the voluntary reduction.
In total, Mr. Nadig calculated BlackRock's annualized revenue on its U.S. ETF product set around $2.4 billion on $939 billion in ETF assets through September. Comparatively, State Street Global Advisors would earn about $879 million on $456 billion in ETF assets under management, and Vanguard Group Inc. is estimated to get $526 million on $576 billion in assets.
For the most part, the fee competition has been isolated to “plain vanilla” funds that held $1.7 trillion in assets and had annualized fees of $3.8 billion, according to FactSet's Mr. Nadig. The remaining products, which include “smart beta,” hedged, leveraged and active ETFs and exchange-traded notes, had annualized fees of $2.25 billion, accounting for only 28% of the exchange-traded product market.
Competitive expense ratio reductions are not exclusive to the U.S. market. On Oct. 17, Vanguard reduced expense ratios on its five Hong Kong-listed ETFs.
As with other investment products, however, expense ratios are not the only cost to be considered in ETF purchase, holding and trading decisions.
Ed Rosenberg, head of ETF capital markets and analytics for Northern Trust Corp.'s FlexShares suite of ETFs, stressed the importance of “total cost of ownership.” He breaks down ETF fees into explicit costs, which include trading costs, the expense ratio, and implicit costs, which include capital gains, turnover, and tracking, and opportunity cost — the fundamental consideration of product preference and index choice.
On Oct. 25, FlexShares announced management fee reductions on six equity ETFs.
“For alternatively weighted ETFs, there's less of a discussion on fees and more on what is behind the strategy,” said Mr. Rosenberg. “What is the fund looking to accomplish and how does the manager go about doing that.”
This more holistic view of ETF activity is more directly relevant to institutional investors who might use ETFs not just for core or strategic exposures, but also for short-term liquidity management and hedging. In fact, few of the largest and most liquid ETFs even track the same index. While some are similar and competitive by design, small differences in index composition or weighting can overcome basis-point-thin expense ratio differences.
“Institutional investors can't just choose the lowest cost ETF,” said Chris Hempstead, head of ETF sales for KCG Holdings Inc. in Jersey City, N.J. “There is a difference between the round-trip implementation costs for a trade vs. a longer holding period. You'll find that certain products designed for high turnover have few users stressing the management fee.”
Brad Thompson, chief investment officer of Stadion Money Management in Watkinsville, Ga., said that “in some cases, it might be advantageous to pay a higher expense ratio for better secondary market liquidity or a higher priced ETF that carries lower transaction costs and commissions.” Stadion sponsored $2.8 billion in managed 401(k) accounts at the end of June, according to Cerulli Associates, and launched an ETF option in February.
“The ETF total return net of commissions during the holding period is the No. 1 metric to measure because it includes the expense ratio. For buy-and-hold positions, an ETF with a lower expense ratio might be better suited,” said Mr. Thompson.
“But for tactical positions, the advantages of better secondary market liquidity and lower transaction costs may offset any minor fee difference.”
As to when and why to reduce expense ratios, some managers are more methodical in their fee reductions, often based on annual reviews, while others are focused on more opportunistic announcements and marketing.
