[Editor’s note: Ben Johnson will be speaking at Morningstar's Investment Conference May 8-10 in Chicago]
Cost is one of the only things investors can truly control, and one of the most important when it comes to investment returns. The good news is that in the past 20 years, fees for open-end mutual funds and ETFs have dropped roughly by half, according to a recent Morningstar study.
Data shows that on an asset-weighted basis, average fund fees dropped year-over-year 6% in 2018 alone to 0.48% (the breakdown shows that average at 0.15% for passive funds vs. 0.67% for active.) That means investors saved an estimated $5.5 billion in fund fees last year. That’s a lot of money, especially considering that in 2000, average asset-weighted fees sat at 0.93%.
There are many factors driving fees lower, chief among them investor demand for cheaper products, Morningstar’s Director of Global ETF Research Ben Johnson says. Johnson, who’s one of the key speakers at the upcoming Morningstar Investment Conference in Chicago, shares here key findings of the study.
ETF.com: Does anything in this trend toward zero surprise you?
Ben Johnson: One of the more surprising findings is just how shrewd investors are being when it comes to the expenses they're paying for funds. This year, for the first time, we looked more granularly at flows within the cheapest 20% of all funds to better understand exactly how shrewd they’re being when it comes to fund selection.
What we saw is that the lion's share of the money went into the low-cost quintile of funds, which in and of itself accounted for all of the net new money going into funds in 2018. People aren’t just looking for less expensive funds, they're increasingly allocating most of their money to the very cheapest of the cheap.
ETF.com: In the passive category, average expense ratio is now 0.15%, and 0.67% for active. The study says that’s the widest disparity since 2000. What’s driving that?
Johnson: “Wide” is measured in terms of the multiple. Relative to 2000, it's a narrowly greater multiple—active investors are paying 4.5 times what passive investors pay on every dollar invested—than it was back in 2000 when we first began measuring this.
It’s not surprising because, generally speaking, money has been flowing into the absolute cheapest of the cheap, and within the cheapest of the cheap, most of it's been going to index-tracking products, be they mutual funds or ETFs. Even more granularly, we know money’s going into funds charging 0.10% or less.
ETF.com: Are active managers not feeling the pinch to bring fees down? Why are they being able to hold on?
Johnson: There are a number of factors at play. One trend is that the cost of the actual management of many active products has been fairly stationary.
Where there have been cases where active funds have gotten relatively cheaper, it's been to the extent that there are cleaner share classes of those funds that are being introduced. Money is flowing out of them, and ultimately many legacy share classes are being shuttered.
So, you haven't seen a ton of movement in the underlying management costs for active funds.
Part of that is there are pockets of the active universe that have held up relatively well, most noticeably in fixed income, where very successful managers have continued to deliver value and justify their charges. You haven't seen that same degree of scrutiny nor pressure on fees in those cases, which are limited, and I would say mostly reside within the fixed-income sphere.
You move over onto the equity side and active stock funds have been the epicenter of the mass exodus from active strategies, broadly speaking. It's mostly been an issue that's plagued active stock pickers, and most notably active stock pickers that have more of a growth orientation.
ETF.com: There’s also the middle ground now, in the form of strategic beta funds. The asset-weighted average fee for strategic beta is only 0.17%. What role is smart beta playing in this fee compression story?
Johnson: I think it becomes a reference point for fund selectors, and for investors when they say, “I've now got something that was the benchmark I used to gauge your performance, Mr. or Mrs. Active Manager, and now it's an investable alternative, and a very inexpensive one at that.”
It becomes a real competitive threat to many forms of active management. They have a meaningful cost advantage and, at least in the case of taxable money to the extent that they're bolted on to an ETF chassis, they have a meaningful tax efficiency advantage as well.
ETF.com: The study finds that a changing advice model toward fee-based advice has also impacted fund fees. Tell us about that.
Johnson: There we still have very important questions; most notably in my mind: Is the $5.5 billion worth of estimated savings on fund fees in 2018 really accruing to the end investor? Or is that simply being displaced by advice fees as more and more advisors move away from being paid on commission to charging a fee for their services?
It’s almost inevitable they’re going to favor lower fee funds to build portfolios on behalf of their clients to leave more room for the fee they charge for not just portfolio management but other services. In a worst-case scenario, this could simply be charging fees that would otherwise not be paid by the clients.
If they were in the commission-driven model and the advisor simply bought them an A-share with a front-end load and let them hold it unperturbed until they proceeded down the decades-long path between where they invested and funding their retirement, on a net/net basis. it puts the burden back on investors all over again to understand, am I really saving these pennies? Are they being invested and compounding to my benefit? Or am I just simply taking money from one pocket and putting it into another?
ETF.com: We’re already looking at zero-fee ETFs. Is there anything that can derail this trend toward lower and lower fees?
Johnson: I don't think this trend abates any time soon. I don't think it reverses, ever.
ETF.com: There’s no question that lower fees is a great win for investors. But have lower and lower fees cost investors in any other way? Have they compromised anything?
Johnson: That's a great question. I would say, on a net/net basis, it's a win/win for investors. If there's any risk in my mind, it's that investors become too narrowly focused on fees and ignore other implicit costs or opportunity costs.
The example that you referenced—the first zero-fee SoFi ETF—is a perfect case in point where, yes, they charge, for the time being, a zero fee; you're not paying anything to invest in them.
But relative to what? It's not as though they've launched a zero-fee total stock market ETF and you can say, at least in theory, if I hold all else equal, I can save 3 basis points a year relative to owning the Vanguard Total Stock Market ETF (VTI).
This is a fundamentally different portfolio. It's a very growth-oriented portfolio. So, what does “free” mean when you have nothing really to compare it to, when there's no like-for-like and when the opportunity costs, as measured in terms of relative performance, might be meaningful?
Should this portfolio over a longer period of time lag alternatives, what does “free” mean then if I've given up 0.50% a year in annualized returns because I was enticed by the notion of a “free ETF”?
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