ETFs Aren’t Always the Most Cost-Effective

Over the last few years there has been a lot of media attention on ETFs (exchange traded funds) and how they have precipitated a “fee war” in the asset management industry. Large asset managers like Vanguard and BlackRock have been accused of inciting a “race to the bottom” in investment management fees, squeezing margins for the industry. We have always been of the opinion that the shift from “high-cost” beta inherent in a lot of traditional mutual funds into lower-cost indexed products is a net benefit for the investing public. While it is the case that for large, vanilla indexed ETF products costs have continued to move lower, this article from Institutional Investor explores a paper that examines the dynamics of ETF fees across the entire industry. The paper cites that at the end of 2018, although there were 28 ETFs which offered an expense ratio at 5 basis points (BPS) or lower, the average annual net expense ratio (when weighted by net assets) across the entire industry actually rose slightly in 2018. The analysis performed by the authors of the paper separates ETFs into two categories; “passive” or “other.” The “other” bucket of ETFs consists of ETFs that are considered more complex and are either actively managed or follow a passive mandate that might be utilizing leverage or an “enhanced” index. The authors of the study found that investors in “passive” ETFs saw expense ratios decrease in 2018, and therefore, the catalyst behind the increase in the average annual net expenses ratio is a result of investors investing new money (or shifting existing money) into more expensive ETFs. While this makes intuitive sense, the results of the study are surprising given how much attention is paid in the media to fee compression from ETF products. Two of the main takeaways from the article are that investors, of all types, should not assume that buying an ETF means that you are utilizing the most cost-effective option, and that there is an appetite from investors to pay higher fees as long as the product is differentiated from traditional beta and can add value to their portfolio.