Swedroe: Zero Expense Ratio ETFs Inevitable

November 21, 2012

The unfolding ETF price war means it’s the best of times for investors and the worst of times for Wall Street, BAM Alliance’s Swedroe says.

The flurry of price-cutting activity in the ETF industry by the likes of Schwab, Vanguard and iShares over the past few months can’t be comfortable to many Wall Street firms who are watching their gravy train of profits slow down, says Larry Swedroe, the director of research at BAM Alliance, the entity that encompasses all $18 billion in assets directly or indirectly linked to Buckingham Asset Management.

When IndexUniverse.com Managing Editor Olly Ludwig caught up with Swedroe in a recent phone visit, Swedroe didn’t disappoint. As we’ve said here before, he is one of the fiercest critics of active management, essentially arguing that a lot of it—if not all of it—amounts to a scam.

But the price competition—which involves even Dimensional Fund Advisors (DFA) that his firm Buckingham has long favored—will almost surely lead to zero-expense-ratio ETFs one day. Always quick to frame his pointed comments colorfully, Swedroe borrowed a page from Charles Dickens saying all of this downward pressure on fund costs amounts to the best of times for investors and the worst of times for Wall Street.


Ludwig: So let’s start with a report card on passive and index investing: What’s your overall view these days?

Swedroe: Well, there’s no army that’s strong enough to defeat an idea whose time has come, and passive investing is an idea whose time has come. However, the trend moves very slowly—kind of like waves eroding beaches. It happens inevitably, but it takes a long time. It’s moving at a pace of maybe 1 percent a year. I think perhaps passive investing makes up maybe 40 percent of the total now. But it’s moving at a very glacial pace, because we’re fighting a very entrenched enemy in Wall Street, as well as the financial media. Most of the media are on the side of active investing because they need investors to believe that someone can tell them which stocks to buy; which managers to choose. That way, everyone has to tune in.

Ludwig: I always enjoy your unequivocal tone, Larry…

Swedroe: ... And Wall Street of course makes a lot more money selling active products than you do selling passive. I mean, look at ETFs: they’re being driven to zero. I fully believe that one day we’ll see an ETF with a zero expense ratio, because you can generate revenue from securities lending.

Ludwig: Let’s talk about that for a moment, the fee compression. This has been a very active autumn: We can go right down the list, Schwab came out and made their 15 ETFs the cheapest in their respective categories; then we saw Vanguard a few weeks later saying they were ditching a relatively expensive index provider in MSCI for cheaper alternatives to help put downward pressure on fees. And then, not two weeks later you have even BlackRock’s iShares rolling out a very cheap lineup of 10 core funds canvassing basic asset classes.

Swedroe: You can be sure BlackRock wasn’t happy about it!

Ludwig: So what’s the takeaway when you take measure of everything that went down?

Swedroe: Well, Schwab—by cutting its fees—is hoping to drive other business to them. For example, Schwab says: “If you use our ETFs, we don’t charge any commissions.” Also, people with assets there might have a money-market account at Schwab, which maybe makes them 60 basis points. And they hope to sell you other things, like a Schwab credit card, or a mortgage—all these other things.

BlackRock, on the other hand, has only one area where they can drive the revenue from, and that’s their investment products. So, the low-cost ETFs are obviously hurting them. But they almost have no choice, unless they can create different, better, more engineered ETFs. And that’s pretty hard to do in the ETF space. You can create some different product, but it’s so easy to copy them, so it’s going to be hard to generate a differentiator so that you charge a premium fee.



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