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.”
What Does The Future Hold?
Industry leaders have their own ideas about where fund costs are headed and the factors and fee tactics leading the way.
Currently, funds generate revenue through “brokerage relationships, securities lending or the fund being part of an advised relationship,” says Joel Dickson, global head of investment research and development at Vanguard. All of these costs don’t directly come out of the investor’s pocket, but they may have indirect effects on fund performance.
But in the future, Dickson says he expects more creative strategies for higher fees with the development of fancy or alternatives ETFs.
“The more complicated the strategy or the greater the risk (funds) allow investors to take on, the higher the cost that firms feel they can charge investors,” said Todd Rosenbluth, director of ETF and Mutual Fund Research at S&P Capital IQ.
On the flip side, ETF expense ratios can move lower, “particularly for niche portfolio holdings or in areas of the market where competition is less fierce,” according to Michael Rawson, an ETF strategist at Morningstar.
Be on the lookout for these fee tactics in a lower-expense-ratio world.
“The costs we see are only part of the fees that investors pay,” said Eli Broverman, Betterment’s chief operating officer. “There are more nefarious ways that broker-dealers charge customers.”
Looking For Cheaper Substitutes
Every quarter, Betterment closely examines the cost characteristics of ETFs in its portfolio. We also keep an eye out for potential substitutes.
If a cheaper ETF emerges, we monitor that ETF and make the appropriate recommendations on a quarterly basis to Betterment’s Investment Committee.
Since we last updated our portfolio—in the second quarter of 2015—the Betterment portfolio has seen, on average, a 4 bp decrease in expense ratio from 20 to 16 bps, or a 20% decrease.
This is a much bigger drop than the smaller decrease of 2 bps from 57 to 55 bps in the average expense ratio of the broader ETF universe, which represents only a 3% drop.
Certain ETFs in the Betterment portfolio also saw a steeper drop in expense ratio than others. For example, small-cap value ETFs as a category saw the biggest drop in expense ratio. The iShares S&P Small-Cap 600 Value (IJS | A-87), which represents the small-cap value component in the Betterment portfolio, saw a 0.05% decrease in expense ratio, from 0.30% to 0.25%.
Similarly, the iShares Russell 2000 Value (IWN | A-91), another small-cap value ETF in our portfolio, saw a 0.11% drop in expense ratio, the biggest decrease of any ETFs in our portfolio.
The 0.06% average decrease in small-cap value ETFs in the Betterment portfolio is much larger than the 0.01% average decrease in small-cap value ETFs in general.
Costs matter a lot to Betterment when choosing the most appropriate ETFs for our clients. And because we don’t invest in expensive alternative or active ETFs, not only is the average expense ratio of the Betterment portfolio lower than the industry average, but the Betterment portfolio sees a more rapid decrease than industry average, and is nicely positioned to benefit from a price war that ultimately benefits investors.
At the time of writing, Betterment held positions in the two securities mentioned. Betterment is the largest, fastest-growing automated investing service, helping people to better manage, protect and grow their wealth through smarter technology. It is a CNBC Disruptor 50 and Webby award winner, and has been featured in the New York Times, Forbes and the Wall Street Journal. Learn more here.