This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Ellie Lan, an analyst on the investment team at the New York-based automated investing service Betterment.
When investing in any ETF, the fund’s expense ratio is usually the most important cost.
Expressed as a percentage of assets deducted for fund expenses, expense ratios include management fees, administrative fees, operating costs, and 12b-1 fees, if applicable.
Expense ratios are also “the most dependable predictor of performance,” according to a Morningstar study. The study showed that funds in the lowest quintile of expense ratios produced the highest total returns, whereas those funds in the most expensive quintile of expense ratios produced returns in the lowest quintile of funds analyzed.
ETFs in particular are driving down the overall costs of investing. This is true both of stock and bond funds, where the average expense ratio dropped from 0.76% to 0.57% during the same time period—a decline of 25%.
The unfortunate flip side is that, as expense ratios decrease, fund companies are now getting creative in attempts to make up for lost revenues. By marketing newer alternatives with more exotic investment strategies, these funds usually are also more costly and potentially riskier to individual investors.
Why Costs Are Getting Cheaper
One important factor is asset growth. When fund assets are small, expense ratios tend to be high, because the fund must meet its expenses from a restricted asset base.
As assets grow, funds have the option to waive expenses that make up the overall expense ratio.
Many funds have a management fee breakpoint where, once hit, their expense ratios are automatically cut. These reductions are meant to be passed on to investors. Technical factors, such as fund inflows, and fundamental factors, such as positive market performance, can cause funds to cross these automatic thresholds.
When fund assets grow (whether from market appreciation or cash flow), a fund achieves economies of scale and expense ratios may decrease.
Another factor to consider is how important expense ratios are to investors. As investors become more price-sensitive, funds with lower expense ratios—but that track the same indexes—tend to win. And so a virtuous circle is born.
Making Up For Lost Revenue
As expense ratios drop, some fund companies without the lowest costs are also getting more creative—from concept to marketing—to make up for lost revenues.
These funds, known as “Alternatives ETFs,” promise exotic strategies that can get investors exposure to assets they can’t get elsewhere. But just because the exposure is unique doesn't mean they will result in higher returns.
Compared with the average U.S.-listed ETF that charges 0.35%, the average alternatives ETF charges 1.29%. Examples of ETF alternatives include: 1) hedge fund strategies;
2) modifications to stock and bond exposure using currency hedging, leverage and options; and 3) volatility-targeting strategies.
In contrast to stock and bond funds, alternatives experienced increases in average expense ratios in the past two decades. In 1990, the average expense ratio of alternative mutual funds cost 1.48%. Today they cost 1.89%—a 0.41% increase.
It’s great that costs are coming down, but some funds are charging lower fees—not because they are lowering the overall inherent costs, but because they are being compensated in other ways.
The added cost may appear in the form of niche ETFs that charge higher costs for unique exposures. It is important that investors understand this shift.
In fact, because expense ratios of alternatives are so high, they generally eat into fund returns. As Vanguard Founder John Bogle once said, “You get what you don’t pay for.”