Hougan: More To iShares Core Than Fee Cuts

The iShares Core launch was pure genius, but it's too early to say if it was a success.

The iShares Core launch was pure genius, but it's too early to say if it was a success.

I agree with my colleague Dave Nadig’s recent blog, iShares Winning Fee War With Itself: The iShares Core launch was a stroke of genius. In fact, I wrote the exact same analysis 15 months ago when the iShares Core products launched. Imitation is the highest form of flattery, I guess, huh Dave?

What’s missing in Dave’s analysis is an answer to this fundamental question: Was the launch of the Core lineup a commercial success?

Let’s look at the numbers.

Viewed simply, the Core lineup brought in solid flows. If you take the seven core equity markets included in the original iShares Core lineup and compare iShares’ flows against its competitors (Vanguard and Schwab) before and after the Core launch, it looks like the smartest business move in the world.

iShares’ share of total net flows into these seven categories rose from 14 percent before the Core launch to 51 percent after the Core launch.

Look closer, however, and the nuances pile up.

The vast majority of that shift is accounted for by flows into one category: emerging markets. For the 15.5 months leading up to the Core launch, iShares lost $1.2 billion in outflows from its MSCI Emerging Markets ETF (EEM | B-99), while Vanguard pulled in an amazing $32 billion in emerging markets assets. Since the launch, that trend has reversed: iShares has pulled in $6.2 billion, while Vanguard has hemorrhaged $11.5 billion.

The other category where iShares has done appreciably better is Developed Markets. Prior to the Core launch, it had just $2.1 billion in flows into the iShares MSCI Developed Markets ETF (EFA | A-91), while Vanguard pulled $5.1 billion into its Vanguard FTSE Developed Markets ETF (VEA | A-91). Since the launch, iShares has topped Vanguard, gathering $10.7 billion in assets against $10.5 billion for Vanguard.

The vast majority of those inflows, however—$8.5 billion of the $10.7 billion—have gone into the old, non-Core iShares MSCI EAFE ETF (EFA), with just $2.2 flowing into the newer, cheaper iShares Core MSCI EAFE ETF (IEFA | A-93)).

Everywhere else is a tossup. For domestically focused ETFs, the iShares’ share of flows is about the same as it was before the Core launch: 37 percent versus 39 percent.

Fee Cut Or Index Shift?

That raises the question, Why has iShares been so successful in the international markets, but only held its ground in U.S. funds?

There are two possible explanations.

The first is that international markets are where the change in fees was most dramatic. When it launched the Core series, iShares’ Emerging Markets ETF (EEM) charged 0.67 percent in expenses compared with 0.20 percent for Vanguard’s fund. That’s a much bigger difference than, say, the S&P 500 space, where iShares charged 0.09 percent and Vanguard charged 0.05 percent.

The second has to do with indexes. A few weeks prior to the iShares Core announcement, Vanguard announced plans to switch benchmarks for many of its ETFs from MSCI to FTSE (for international ETFs) and CRSP (for domestic ETFs). Before that, iShares and Vanguard used the exact same indexes for international exposure.

The single biggest impact of the MSCI/FTSE switch came in emerging markets.

MSCI counts South Korea as an emerging markets country, and it makes up 15.5 percent and is the top holding of the MSCI Emerging Markets index and EEM. FTSE considers South Korea a developed market, meaning it has zero weight in its emerging markets index.

With many investors benchmarked against MSCI indexes, Vanguard’s shift sent a ton of assets iShares’ way. This switch also helps explain why iShares’ EFA—a noncore ETF covering developed markets internationally—saw significant gains in market share in the past year-plus as well.

Why Core Is Still Genius

In the end, I don’t think you can separate the two. The combination of lower fees and the Vanguard index switch laid the groundwork for iShares’ dramatic increase in its market share of inflows.

If iShares hadn’t launched a lower-cost emerging market ETF as part of the Core series, more advisors and institutions would have stuck with Vanguard and accepted the FTSE index. Because iShares narrowed the fee gap, they didn’t have to.

What the iShares’ Core launch really did was neutralize the key competitive advantage Vanguard and Schwab had when it came to fees and forced them to compete on the edges. Prior to the Core launch, Vanguard or Schwab could walk into client meetings, paint iShares as overpriced and win assets on that argument alone.

By being competitive, iShares forces Vanguard and Schwab to compete on questions like fund management, trading spreads, commissions, support services and other nuanced topics. iShares is happy to compete at that level.

Of course, the real winner in all this is investors. Regardless of the commercial dynamic, broad-based exposure to market beta is cheaper now than at any time in history.

And that’s a very good thing.

At the time this article was written, the author held long positions in IEMG, VWO, VTI, VEA and IEFA. Contact Matt Hougan at [email protected].