Why ETFs are only going to get cheaper

One of the core arguments for investing using passive funds and exchange-traded funds (ETFs) in particular, is that they’re cheap. Why take the risk of paying more for an active manager when odds are, you’ll get a better outcome at a lower cost from an index tracker? It’s a great argument, and a key selling point. But what if ETFs are still too expensive? What if the truth is that consumers are still being charged too much?

The great ETF ‘rip-off’

The question arises after French asset manager Lyxor, Europe’s second-largest ETF provider, announced the launch of its new range of “core” ETFs, covering everything from British to Japanese stock markets, as well as gilts and US treasuries on the government bond side. The range consists of four new ETFs, plus 12 that have had their prices cut. The charges are the lowest in Europe, according to Lyxor, and they even rival the US, historically the home of the cheapest ETFs around. Both the Lyxor Core Morningstar UK and US ETFs charge just 0.04% a year, while even an ETF tracking a traditionally more expensive “exotic” market – like Japan – costs just 0.12% (although the latter is, in fact, not the cheapest Japan ETF available in Europe – the Xtrackers Nikkei 225 ETF charges 0.09%).

The range is physically-backed (so each ETF owns the components of the index it tracks) and the ETFs do not engage in securities lending. Lyxor UK CEO Matthieu Mouly told Professional Adviser: “We hope we have found a floor to the price because when you go below 0.04% it starts to become complicated.”

At the 0.04% level, the fee is practically negligible for the average private investor. Yet there are suggestions that this race to the bottom could go even further. In the US, for example, State Street Global Advisers already offers various S&P 500 ETFs with fees of 0.03%. Clearly, scale makes this possible – a one basis point fee on $10bn of assets is a much more attractive proposition than a one percentage point fee on $10m of assets. And there’s something of a virtuous loop here for investors – as a company attracts more assets, it can afford to cut fees further, and as a result attract more assets, and so on.

Some predict that we could eventually see even cheaper or even entirely fee-free ETFs. How so? One option is that big managers may offer the most popular ETFs as loss leaders, in the hope that by attracting a big client’s “core” business, they’ll be able to sell them other, more profitable funds as well – or simply drive out the competition. However, it’s also possible that fees raised by ETF providers by lending securities to short-sellers (for example), could make it possible – at a given scale – to offer an ETF with a 0% fee, yet still make a small profit.

Clearly this is bad news for the fund management industry in general. The spectre of Amazon launching into financial services has haunted many an active manager for years, but this is precisely what’s already happening in the ETF and passive sector, without Jeff Bezos even nodding in its direction. We’re seeing the “Amazon-isation” of fees, whereby the quest for market share is ruthlessly exposing anyone who is charging anything more than the absolute minimum for their services.

Active managers will continue to lose market share, with the largest players likely to be the biggest victims – they will be left unable to compete on scale and price with the big passive providers, while also lacking the agility to compete on performance with the best-known “boutique” active managers.

It also suggests that there will be increasing pressure on even the more “sophisticated” ETF products – from smart beta to other niche offerings, prices will continue to be driven down (I still remember the days when getting a Japan ETF for less than 0.7% looked like a bargain!)

Remember – low costs don’t make you a better trader

Clearly this is all very good news for small investors. But just be aware of a few things. First, annual fees are just one of the costs to consider. You also have to look at less obvious costs such as liquidity (the bid-ask spread) and tracking error (the lower the better). Second, there’s an important psychological point to remember too. Low investment costs are great, but don’t let that fact mislead you into believing that trading carries no cost. Most studies show that investors are dreadful market timers, and even excluding trading costs, the impact of switching between funds, or in and out of markets, is hugely negative for the average small investor.

The real winners from this race to the bottom will be the investors who can sit back, resist the temptation to chase after every trend, and allow the benefits of their ultra-low or non-existent charges to compound up over time.

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