Zero is not the floor - it's the beginning

Timo Pfeiffer

Fidelity's zero-cost funds move is a game-changer for the entire industry. With its announcement of the first zero-cost index funds in the US, Fidelity has sent shares of major ETF managers south amid investors' fear for their business model.

And I think, it is just the beginning. Distributed ledger technologies such as blockchain have the potential to disrupt the settlement market and new peer-to-peer trading platforms such as Robinhood are competing with traditional exchanges.

At the same time, websites like Yahoo Finance are democratizing access to financial data.

"Our fees will go towards zero - without actually touching it," said Tim Buckley, Vanguard ÃÅs chief executive, in a recent interview with German financial daily Handelsblatt.

I actually agree that there is a clear race to zero. But I have a different view on the actual end stage. Let me tell you why.

Race to zero

Cost pressures have been enormous in an industry in which the added value of the fund manager is becoming less and less valued by investors. Active managers feel the strongest pressure as their business model underperforms - measured by the money inflow - against low-cost passive investment funds. Investors pay an average of 1.4% for an actively-managed equity fund whereas passive equity ones cost around 0.6% in fees.

Fees that are still significant when displayed in absolute terms.

The jump to zero hasn't come as a surprise, but rather the next intuitive step. The cheapest ETFs or index funds already charge less than 0.1%. Currently, over 400 ETFs listed on etfsearch.com have an expense ratio lower than 0.2%, and investors are starting to question the pricing policy of many of the higher priced Index Funds.

Surely, not every expensive ETF is a rip-off and fees should never be the sole criteria when choosing an ETF investment. Many thematic and complex ETFs and their corresponding indices have higher costs due to the underlying intellectual property and value-add.

But when we look at simple, market-cap weighted pure beta indices, their rebalancing costs are low, their construction methodologies are extremely simple, and they have been around for almost a century.

The corresponding 'cheap beta' ETFs and index funds are consequently facing most pressure towards zero as seen with Fidelity. They are usually large and also offer the issuer alternative ways of earning money through other means than management fees.

Making money with zero-cost funds

One option people often talk about to cover the costs of an ETF and allow Fidelity - and others - to operate a zero-cost fund is lending shares to short-sellers. Many funds have specific rules on how many of the shares can be lent to short-sellers with numbers ranging somewhere between 20% to 50% of their total assets.

This can clearly be a way to generate some income on top of the management fee, but at least some of these benefits are also for the fund ÃÅs investors and overall only account for a smaller amount.

I think that still the main argument is more aligned with strategies where the issuer has other products or services on shelf to offer to the same client base. And thinking of Amazon, where the marketplace with its millions of participants generates invaluable market intelligence, a large ETF or Index Fund as such can provide similar value through its market insights, money flows and data points associated with it.

From my perspective, the pressure on ETF issuers to lower their existing costs will continue. And index providers are part of that game. In a world where some major index providers still operate with margins north of 70% and charge basis points in fees for plain market-cap weighted indices, it won't come as a surprise that also the indexing world is facing major disruptions.

Automation is driving costs down, and is opening doors for disruptive, flat-fee models and different service levels - just ask your cab driver about UBER.

Looking at major expenses of ETFs, we can see where they are heading. Starting with listings, they are nowadays often offered free of charge or actually even being paid for by the exchanges.

I have already mentioned above the disruptive potential of blockchain technology on custody and think it is fair to say that this will also drive expenses down further. That leaves us with index fees: traditional index providers will often tell you that their index adds value to an ETF, while I believe, it's actually the opposite. Especially for pure beta, market-cap weighted indices, an index provider can gain a lot of exposure and reputation through a giant ETF tracking such indices. Should the index provider pay a premium in such cases? Yes, I am sure such a 'negative fees' scenario is not far away any more. So, dear SPY out there, are you listening? Will the race to zero really end at zero? I don't think so.

Timo Pfeiffer is head of research and business development at index provider Solactive.


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