Free ETFs Don’t Work

March 05, 2012

 

A History Lesson

If history holds any lessons, then one of them is that zero expense ratios haven’t worked in the past either.In 2009, Old Mutual Global Index Trackers launched the GlobalShares FTSE Emerging Markets Index Fund (GSR)—which is now delisted—with a two-month fee exemption, and an expense ratio of 39 bps thereafter.

Ten months later, GSR had accumulated less than $10 million above seed capital. Meanwhile, the Schwab Emerging Markets Equity ETF (NYSEArca: SCHE), which launched a month after GSR, managed to accumulate $233 million above its seed capital.

SCHE’s expense ratio at launch was 25 bps—the cheapest in class at the time—which goes to show that low expense ratios can attract investors to a product. But the nuance here seems to be that investors are not as likely to be hoodwinked by gimmicks surrounding management fee waivers.

Getting The Short End Of The Stick

Only market makers seem to benefit from temporary 100 percent fee waivers, since it allows them to hold a large inventory of shares at no cost.

Investors who don’t know any better may be caught off guard once the expense ratio jumps and a given fund’s assets nose-dives. Those who do know better will instead choose a fund with lower holding cost from the get-go, as SCHE’s successful launch clearly demonstrates.

Although it may seem like a good idea at first, zero expense ratios take away from a fund’s strengths and put too much focus on holdings costs alone. That’s a shame, because the prices for KBWR, KBWB, KBWC and KBWI have appreciated by an average of 17.45 percent since launch.

Still, the way fund providers make money is through management fees. No matter how good a fund is, if it doesn’t have enough dollars invested—it will close.

PowerShares is now left with two funds that have few assets—KBWC and KBWI are each below $5 million. Fortunately, the PowerShares KBW funds are young and still have the chance to gain momentum. I just hope they didn’t shoot themselves in the foot already.

 

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