Nadig: iShares Winning Fee War With Itself

July 07, 2014

How BlackRock's iShares is seemingly battling itself with competing funds—and winning.

I will admit I was puzzled by the launch of iShares' Core series back in October 2012. Let me paint you a scenario: I have a goose that lays golden eggs. Every day, as long as I feed it corn, it lays a golden egg. But I only have one bag of corn a day, so I only get a golf-ball-sized egg.

Then I tell you I've found this other goose that lays eggs made out of tin. But I love this goose so much that I'm going to adopt it, put it next to the awesome gold-laying goose and share the corn.

You'd say I'm insane. And you'd be right. You could also say I'm iShares.

In October 2012, BlackRock launched its tin-laying goose series, known as the iShares Core. The concept of the iShares Core is simple: easy to understand, low-cost exposure to core asset classes. It was in direct response to the success Vanguard and Schwab had had with similar products, and a recognition that ETFs were increasingly being used not just as trading vehicles, but as the bedrock of entire long-term portfolios.

All well and good. But how they went about it was interesting. They rebranded some funds, like the popular iShares S&P 500 fund (IVV | A-98) by just sticking "Core" after the "iShares." But with other funds, they launched brand new funds with nearly identical exposures, at lower fees.

The three real head-scratchers were competitive products to the iShares MSCI ACWI ex U.S. ETF (ACWX | B-97), the iShares MSCI Emerging Markets ETF (EEM | B-99) and the iShares MSCI EAFE ETF (EFA | A-91).

iShares Core Launches

Name Ticker Expense Ratio
iShares MSCI ACWI ex. U.S. ETF ACWX 0.33%
iShares MSCI Emerging Markets EEM 0.68%
iShares MSCI EAFE EFA 0.33%
iShares Core MSCI Total International Stock IXUS 0.16%
iShares Core MSCI Emerging Markets IEMG 0.18%
iShares Core MSCI EAFE IEFA 0.14%

When I say these products were similar, I'm making an understatement. In each case, the new "core" products track what's actually a better version of the MSCI index in question. The iShares Core MSCI EAFE ETF (IEFA | A-93), for instance, tracks the "investable markets index" version of the Europe/Asia/Far East, which extends its coverage down into small and even micro caps (and which earn it, consequently, a higher fit score than the iShares MSSCI EAFE ETF).

The Performance Advantage

Put another way, it's not only cheaper, it's better. And in fact, if you look at the performance of all six of these ETFs since the launch of the core series, every single one of the core products has been objectively better for investors.

iSharesCorePerf

Source: Bloomberg

Over the nearly two-year period, each Core product is outperforming its old counterpart by anywhere from 1-2 percent.

Some of that's exposure having better exposure. Some of it's being cheaper. But the third piece is even more interesting—tracking difference. Let's just stick with EAFA as our example. Here are the tracking difference stats for the old fund, EFA:

EFATD

And here they are for the Core fund, IEFA:

IEFATD

 

These are just clipped straight off the Efficiency tab here at ETF.com. The way to think about our tracking difference stat is "how far behind the index was an investor over a typical one-year period over the last two years?" You're baseline expectation should always be "I'll be as behind as the expense ratio."

So with the first fund, EFA, your median experience was that you trailed your index by 15 basis points—that's not too shabby at all, considering you would normally expect to be behind by the 33 bps in expenses you're paying.

But look at IEFA! You're median expectation is that you beat your index by 18 bps! Not only aren't you behind by your 14 bps expense ratio, you're ahead of the game!

There are two things that can explain this. The first is securities lending. Both funds loan out securities to short-sellers for a fee. It's possible that IEFA, because it holds micro- and small-caps, might be able to eke out a bit more profit from that activity.

The second possibility is optimization, because IEFA's underlying index is massive—3,100 securities—of which IEFA owns about 2,500. That's 600 securities or so not held. Picking the right ones to avoid can make a real difference, and we see this at work in each of the funds.

So the Core funds are not just better, they're demonstrably better.

The Revenue Hit

So if the new funds are simply improvements, why didn't iShares simply replace the old funds with the new ones? As with most things in finance, it's all about the Benjamins. EEM and EFA are two of iShares largest funds, with more than $40 billion and $56 billion in assets, respectively. They're also some of their highest-priced funds—EEM's expense ratio is a whopping 67 basis points.

So iShares engaged in a little sleight of hand. By picking slightly different indexes, iShares can tell the story about how they're leaving the enormously liquid old products alone for the benefit of folks who need to trade a lot.

By not using the IMI index that includes the less liquid stocks, the old funds will (the story goes) be able to maintain their phenomenal trading stature. For a certain kind of investor, that will matter more than the enormous fee difference.

Well, it turns out they were right—at least, they were right in that assets in those older, more expensive ETFs have generally stuck around. Here's the rundown between the six funds in terms of assets and fees actually collected (calculated daily) since the launch of the core series:

Fees Collected (10/15/2012 - 07/03/2014)

Name Ticker Assets ($, MM) ER Fees ($,MM)
iShares MSCI ACWI ex. U.S. ETF ACWX 1,757 0.33% 8.62
iShares MSCI Emerging Markets EEM 40,440 0.68% 465.80
iShares MSCI EAFE EFA 56,684 0.33% 258.90
733.32
iShares Core MSCI Total International Stock IXUS 782 0.16% 0.76
iShares Core MSCI Emerging Markets IEMG 4,894 0.18% 5.83
iShares Core MSCI EAFE IEFA 2,462 0.14% 2.87
9.45

While the core launch has been successful by any rational standard—pulling in more than $8 billion in less than two years—the funds are hardly a threat to the established ones.

And the fee differential? Well, it's hard to argue that $733 million is a lot of money to collect off three funds. If the money that came into the core products had instead gone into the older, more expensive products, it would have only contributed an additional $10 million in fees to BlackRock's bottom line.

But if BlackRock had simply cut the fees on the existing products to make them palatable to long-term buy-and-hold investors? Disaster. Instead of earning $733 million in fees, those funds would have yielded just $237 million. Yes, you read that right. It's a half-a-BILLION-dollar problem to simply drop the fees on ACWX, EEM and EFA.

By launching the new funds with a new purpose, BlackRock was counting on the fact that ETF money is enormously sticky. And when it comes to funds with entrenched brands and phenomenal liquidity, it can take years and years for investors to realize there's a better option sitting right in front of them.

My prediction? Slowly but surely we'll see the new money coming into iShares go to the Core line. In the long term, better performance generally wins in the investment business. But traders? Until there's a real sea change in volumes and spreads, they'll stick with the older, more expensive products.

And BlackRock can keep cashing that half-billion-dollar check.


At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].

 

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