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How Inexpensive Can ETFs Get?

In some cases, the fund provider pays you to invest (not including asset performance).

Paul Justice, 12/17/2009

The pricing wars are under way in ETF land, and investors are enjoying all the spoils. At Morningstar, we've done countless studies on the best predictors of future fund returns, and the best indicator, hands down, is fees--the lower, the better.

In recent weeks, we've seen several "me too" vanilla funds hit the market, differentiated only by their slightly lower management fees compared with existing funds. Charles Schwab shook up the landscape as well, offering six extremely low-cost broadly diversified equity funds that can be traded for free on the Schwab platform, and Old Mutual jumped into the ETF fray with a limited-time offer of zero fees on its new emerging-markets fund. (Limited-time offers on long-term strategies don't really seem appealing to me, but that's a different topic entirely).

This form of competition points to the commodification of several ETF asset classes. When price is the only way that products become differentiated, the investor becomes the beneficiary of eroding provider competitive advantages (what our stock analysts would call a "narrowing moat"). Existing providers will likely have to lower their fees to preserve their first mover advantages that led to asset accumulation or watch the competition move into their turf.

The other way to maintain profitable fees is through product innovation, and there is still plenty of runway left for successful new product launches despite the product proliferation. Areas that have not yet been bombed with products include the corporate credit space, alternative investments, unique factor concepts, and more long-short commodity strategies. Over the next two years, we expect many product launches in these arenas that can still sport the 0.50% plus fees we've seen elsewhere in the ETF landscape.

One area where I don't see new competitors emerging in the near future is in the domestic-equity sector space. Between iShares, Vanguard, and the Select Sector SPDRs, there is already fierce pricing competition, and the amount of assets that will likely invest based on sectors appears finite enough to be supported by these three providers. Besides, how good of a deal can investors really expect their product providers to dish out?

Take the Financial Select Sector SPDR XLF, for instance. First, let's look at the downside of this fund. Had you owned it for the one-year period ended Sept. 30, 2009, you would have lost 23.21%. That's completely understandable because it was a really bad year for financial stocks. However, if you take a look at the index that the fund was trying to replicate, you'll see that you should have lost 23.47%, or 26 more basis points than you actually did.

When an index-based ETF, which has strict rules against any kind of active management, outperforms its benchmark, two sources of performance deviation come to mind. First, an ETF is traded on exchanges, and it is subject to trading at small premiums and discounts to its net asset value. When this is not the source of the differential, thoughts then turn to tracking error.

Index funds have two main sources of tracking error. First, if any fund holdings change over the course of the year, absolutely perfect replication of an index is extremely difficult, so minor variations in performance arise from the composition differences of the portfolio and its benchmark. The primary culprit of tracking error, however, is the cost of constructing the portfolio: trading costs and management fees. If there is anything nice about paying fees, it's that they are easy to quantify. Therefore, if your fund underperforms the index by exactly the management fee, you know the fund provider is doing a good job replicating the investment exposure you seek.

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