How Low Can ETF Fees Go?

This article is part of Morningstar's Guide to Passive Investing special report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Fee wars have been raging among exchange-traded fund providers, but do they have room to move any lower? Joining me to discuss that topic is Ben Johnson. He is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, let's talk about the state of the state in terms of fund fees, fund expense ratios among ETFs. Would you say they are as low as they can go at this point?

Johnson: You've seen among ETF providers, and providers of index mutual funds as well over the course of the past few years, almost a game of fee limbo. We are asking now, how low can these fees really go? In some cases, you can look at a total stock market index portfolio and see fees on funds that are readily available to retail investors as low as 3 basis points; $3 on a $10,000 investment. That's incredibly low.

So, what you see now is that, first and foremost, the fee war, this fee fighting, is beginning to spread away from total stock and total bond market indexes into index funds and ETFs that offer exposure to narrower slices of the market, and ETFs and index funds that offer exposure to more complex strategies. These might be factor funds, what we call strategic-beta ETFs. The most notable data point in recent months on that front was the launch of Vanguard's first actively managed factor ETFs, which charge fees of 13 basis points. The fee fighting is spreading, and fees are drawing ever nearer zero.

Benz: You say that providers are working to bring fees down, even fees that aren't reflected in expense ratios. They are looking at turnover, they are looking at their strategies and the extent to which they can incur fees. Let's talk about that dimension.

Johnson: In the case of these less visible fees, it's important to understand that the headline expense ratio isn't the only toll that's being taken when it comes to managing these portfolios, that there is some degree of turnover. What you are seeing is that indexes themselves are beginning to evolve to try to help to mitigate some of those implicit costs, the ones that investors frankly will never see.

A prominent case in point would be changes to the CRSP series of indexes and these are the indexes that underpin Vanguard's U.S. index funds and exchange-traded funds. Beginning last year, these indexes moved from turning their portfolios over over a one-day period to now turning them over over a five-day period to smooth out those transactions and to minimize the market impact, the potential that these trades might be picked off by front-runners, people trying to profit knowing full well that these portfolios will be trading in certain securities, you name it. There are going to, I think, continue to be developments on that front as we've seen fees reach, again, near zero levels to otherwise minimize the less apparent, the less transparent costs that are associated with managing index portfolios.

Benz: On the expense ratio side, you say firms are also looking really hard at other ways to try to reduce costs, or other ways to mitigate the expense ratio. Let's talk about some of those. You said they are just trying to reduce the number of paper mailings, for example. What other steps are they taking?

Johnson: Absolutely. They are looking in every dark corner of their operations trying to understand how they can squeeze out efficiencies, squeeze out costs. As you alluded to, part of that is just the paper materials that an investor might receive in the mail. How do we take pages out of our annual report, slim that down to save on printing and mailing costs? You are really talking about pinching pennies when it comes to looking at costs at the level of the fund sponsors themselves.

They are also looking at other avenues via which they can generate revenues. One of those that's particularly relevant in the context of index portfolios is securities lending. Index portfolios tend to be fairly stable. The managers of those portfolios can loan out, say, the stocks in S&P 500 index fund to people who might want to typically sell those stocks short and earn revenue in return. Again, as these fees draw ever nearer zero, index fund sponsors, ETF sponsors are thinking out loud about how they can drive down costs and other ways that they could potentially generate semireliable revenue streams to create more space to bring down fees an inch or two further.

Benz: The securities lending does have repercussions for the expense ratio. There's the potential for it to put some downward pressure on the expense ratio.

Johnson: Absolutely. Even today, if you were to look at the performance of many index funds relative to their benchmark index, there are cases where the securities lending program that's in place generates revenue that partially, or in some cases, entirely offsets the amount of fees that are extracted from that same portfolio so that even on a net of fees basis, these funds are tracking their benchmarks perfectly.

Benz: Let's talk about how investors should approach this. You say that even though this fee war has been a positive for consumers, there's a potential for investors to be a little bit penny wise and pound foolish if they are overly focused on the expense ratio at the expense of all the other things that should factor into their decision-making. Let's talk about that.

Johnson: Absolutely. I think there are real risks to becoming fee obsessed. I don't want to discount by any stretch of the imagination the importance of fees when it comes to selecting investment products …

Benz: Especially, if it's just a cap-weighted index fund, right?

Johnson: Absolutely. Selecting among commodities, right? Deciding to go to one corner gas station versus another. The end outcome, the end product really is going to be substantially identical. Where it becomes particularly worrisome, this fee obsession, is in those cases where you have not commodity products but more differentiated products--strategic beta ETFs, these factor-oriented strategies, which if you line up similarly labeled funds, say, funds that have the word value in their name, what you will see over a three-, a five-, a 10-year period is that the outcome of those strategies as measured by the return and the risk profile of the portfolio is going to vary widely. There's going to be huge dispersion.

Focusing obsessively over whether I should pay 13 basis points for that value strategy or 25 basis points for that value strategy puts investors at risk. As you described it, it's being a penny wise and a pound foolish. It's really important to understand the makeup of that strategy, be it an index or be it an active strategy because that ultimately will matter more over the long term, will be the bigger driver of investors' returns over the long term than saving a penny or two here or there on fees.

Benz: Ben, great advice. Always great to hear your insights. Thanks for being here.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.