Recipe For ETF Success: Scale & Network Effect

October 28, 2016

ETFs, Scale Advantages & The True Network Effect

With ETFs, the story is almost precisely the opposite.

Because most ETFs track indexes, the problem of finding alpha is largely irrelevant. Meanwhile, the benefits of scale are immediate: Because ETFs don’t deal with individual shareholders directly, the amount of effort required to run a $10 billion ETF is very similar to the amount required to run a $10 million ETF.

You see the impact of this in the relentless expense ratio declines we’ve seen in the ETF space as it’s grown. The table below looks at three core categories of exposure for investors: U.S. equity, emerging markets and fixed income. 

 

Asset Category Ticker Expense Ratio When Launched Expense Ratio Today Cheapest Competitor Expense Decline
S&P 500 SPY 0.16% 0.09% 0.03% 81%
Emerging Markets EEM 0.75% 0.68% 0.14% 81%
Fixed Income AGG 0.20% 0.05% 0.05% 75%

 

In each case, when ETFs entered the market, they were instantly among the cheapest ways to gain exposure to the market. But since then, the relentless impact of scale and competition has pushed down prices between 75% and 81%.

ETF Shareholder Interaction & Liquidity

Whereas mutual fund expense ratios trickle lower as they grow, ETF expense ratios crash toward zero. It is a pricing trend you see in virtually any business with high levels of competition where the marginal cost of growing the business is close to zero.

Scale, however, is only half the story: There is also a direct benefit from ETF shareholders interacting with one another.

One clear place you see this is in spreads: The more trading there is in an ETF, the tighter the spreads and the cheaper it is to trade. But something special happens as ETFs truly get large.

Generally speaking, the liquidity of an ETF is typically a reflection of the liquidity of its underlying securities. But truly large ETFs can actually be more liquid than their underlying securities.

That’s how funds like the SPDR High Yield Bond ETF (JNK) or the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) can trade at $0.01 spreads while holding securities that trade at $1 spreads. With traditional mutual funds, no amount of scale will achieve this result.

Network Effect Boosts Tax Efficiency

The bigger place you see the impact of the network, however, is on tax efficiency. The tax efficiency of an ETF is driven by creation/redemption activity.

Specifically, when ETF shares are redeemed, the ETF has an opportunity to expunge its portfolio of securities with built-in capital gains, because these transactions occur in-kind. The more redemption activity, the more tax-efficient ETFs become.

This is why large, liquid equity ETFs virtually never pay out capital gains. Conversely, large mutual funds often have large embedded capital gains. When investors redeem shares, capital gains are generated that must be distributed to other shareholders.

In short, bigger is better in ETFs, while bigger is typically worse in traditional mutual funds. That is yet one more reason why the “avalanche” of flows out of mutual funds and into ETFs will only continue.

Matt Hougan is CEO of Inside ETFs, a division of Informa PLC. At the time of this writing, the author held none of the securities mentioned. He can be reached at [email protected].

 

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