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The exchange traded funds industry is a case study in pure, unbridled capitalism and that’s true on multiple fronts.
By the standards of the financial services sector, ETFs are disruptive. In the U.S., that disruption started with the 1993 debut of the SPDR® S&P 500® ETF Trust (NYSEARCA:SPY) and the “victims” of that disruption have been actively managed mutual funds.
The other part of the capitalism equation playing out in the world of ETFs is issuers competing with each other on costs. Name the industry and chances are firms within it tussle with each other in a bid to leverage favorable costs as customer acquisition tools.
For ETF issuers, they know that cheap funds have a receptive audience – one that’s largely comprised of registered investment advisors. However, competition, while good for consumers, isn’t always great for its purveyors. That much is highlighted in a recent Citigroup report that indicates roughly 50% of the 3,300 exchange traded products listed in the U.S. are money losers for their issuers.
Cheap is Good for Clients, But…
Obviously, when it comes to capitalistic sectors, financial services reigns supreme, but when it comes to ETFs, the issue with the ongoing fee war is, well, it’s ongoing. This isn’t an airline fare war of yesteryear that would last a few months. Not at all.
Rather, fund fees (ETFs, index funds and mutual funds) have been steadily declining and advisors and clients are proving responsive to that trend.
“In eight of the last nine years, the cheapest 20% of funds across all Morningstar Categories have, as a group, accounted for 100% of the net inflows into all funds,” notes Morningstar. “Money has poured out of the remaining 80% during that time. The sums are staggering: More than $5.4 trillion has flowed into the low-cost cohort during this eight-year span, while $2.6 trillion has been pulled from the remaining funds.”
In other words, it’s not surprising that many ETFs aren’t making money for their issuers. As Bloomberg reports, a single ETF faces annual fixed operational costs of $200,000 to $350,000 plus another 7.5 basis points in variable costs. So at the midpoint of that range, it’s possible that an issuer can spend $280,000-ish on a single ETF in a given year simply to keep the fund’s proverbial doors open.
If the assets aren’t there to start or the fund suffers outflows, that $280,000 fund-level losses even for behemoth ETF issuers.
How ETF Industry Can Cope
No one should feel sorry for fund issuers, but it’s worth noting fee compression still has some room to the downside. Believe it or not that’s true even with the 100 cheapest ETFs featuring seven funds with annual expense ratios of 0.00% and none exceeding yearly fees of 0.05%. Some issuers have avenues for dealing with paltry fees.
“In a maturing industry, there are still profits to be had, but success is not necessarily widespread,” Citi analysts including Scott Chronert wrote in the report. “Typically, strategies with higher associated fees tend to have greater percentages of covering their operating costs or earning more significant fees for their issuer.”
In other words, go ahead and buy that artificial intelligence (AI) ETF, that cannabis ETF or that video game ETF because the issuer could use the support. Alright, that was said in jest, but the point is issuers need to make money somehow and it’s usually exotic or unique products that accomplish that goal.