The 2019 J.P. Morgan Global ETF Handbook provides a detailed overview of the $5.6 trillion global ETF market, examining the latest market developments, with a complete listing of all ETFs trading worldwide. Here, J.P. Morgan Research takes a look at how the fee war is changing the shape of the industry. The race to the bottom for ETF fees has plummeted to new lows, with the launch of the first funds with zero management and even negative fees earlier this year.
Exchange-Traded Funds (ETF) fees have been persistently squeezed by competitive forces in recent years, as investor appetite for passive strategies and lower fee products continues to grow. This, combined with the challenge from new fintech entrants to the market and increased competition among established players for market share has forced costs sharply lower, saving investors billions of dollars in recent years. Average fees paid across U.S. ETFs have decreased by around 40% since 2012 (from an assets under management (AUM) weighted average of around 33.5 basis points to 20.5 bps).
“This lower fee trend has been driven both by investor flows gravitating towards lower fee funds within each region and asset class and the move by ETF issuers to selectively cut the expense ratio on a number of funds,” wrote J.P. Morgan Global Quantitative and Derivatives Strategists, Marko Kolanovic and Bram Kaplan.
This year alone, asset manager Vanguard has cut fees across 21 of its largest ETFs, with these funds currently holding around $660 billion under management. All things being equal, the reductions will save investors in the region of $88 million in fees per year – and data shows this strategy is working. Investors have flocked towards the lowest fee funds, with the cheapest capturing the bulk of net inflows in the ETF space. Funds in the lowest quintile by expense ratio, or those with an expense ratio of less than or equal to 24 bps, attracted around 80% of all net inflows to U.S. ETFs over the past five years.
The lowest 20% by expense ratio captured 80% of flows, while the remaining 80% of funds saw just 20% of flows.
“In other words, the lowest 20% by expense ratio captured 80% of flows, while the remaining 80% of funds saw just 20% of flows,” wrote Kolanovic and Kaplan.
More recently, this gap has widened further. ETFs in the lowest fee quintile pulled in 97% of all net flows during the past year – the 80% most expensive funds saw close to zero of the $300 billion of new cash invested into U.S. ETFs over the last year.
This fee sensitivity was more pronounced in equities than fixed income. Equity funds with the cheapest fees attracted 82% of all net inflows over the past five years, while the equivalent figure for fixed income ETFs was 55%. For fixed income, this disparity can be partly explained by the fact that fee levels are lower overall and the popular iShares Treasury bond ETFs all fall within the second fee quintile of their asset class.
Different types of ETFs have been swept up in the fee war to varying degrees, with fees for ETFs with broad exposures falling by much more than those with narrower exposures. Average fees in broad U.S. equity and fixed income funds fell by around 40% since 2012, while sector and factor ETF fees fell by a more modest 25%. Meanwhile, ETFs providing exposure to individual countries or international sectors and themes saw single-digit percentage fee declines and commodity funds on average saw no decline. The smaller fee declines in niche products can likely be explained by the fact they have smaller pools of assets (and thus lower economies of scale), face less competition, and often have higher trading costs due to lower liquidity.
Similarly, actively managed ETFs recorded a smaller decline in fees compared to passive ETFs in recent years. Investors tend to focus more on active funds’ returns/alpha than cost and their differentiated strategies result in less competition. On an AUM-weighted basis, actively-managed funds in aggregate have seen the same 9 bp decline in fees as passive funds since 2014, but this represented just a 15% drop on average for actively-managed funds compared with 32% for passive funds.
“Almost all of the decline in AUM-weighted fees for actively managed funds came over the past year and most of this decline is due to investor flows into lower fee actively managed funds, rather than expense ratio cuts by the funds themselves,” wrote Kolanovic and Kaplan.
Up until very recently, ETFs generally had to disclose their holdings daily—a factor that was seen as a major impediment to active managers’ broader adoption of the ETF structure. Such disclosures are problematic for active managers because they broadcast to the market exactly what the fund is holding, buying and selling. This permits their strategies to be reverse-engineered or even front-run. ETF providers have submitted a number of proposals to the Securities and Exchange Commission (SEC), over the better part of the past decade, for non-transparent ETF structures that would alleviate this problem. In April 2019, the SEC issued a notice indicating that it would approve the first non-transparent ETF structure that trades like a traditional ETF—Precidian’s ActiveShares structure—but final approval is delayed as the SEC addresses a competitor’s comments. Other providers have also since filed for SEC approval of non-transparent ETFs—a new category that will allow asset managers to actively manage a fund, as mutual-fund managers do, without having to disclose all of the fund’s investments every day.
Another recent trend in the ETF fee war is for major ETF issuers to relaunch or rebrand lower fee versions of simple market beta or “core” products in order to capture flows, largely from “buy and hold” investors seeking the cheapest passive products. These products have been at the front lines of the fee war, as they have seen repeated fee cuts and attracted large asset inflows in recent years. Examples of these core products include: iShares’ Core suite of 25 funds across asset classes, SPDR’s Ultra-Low-Cost Core ETFs, Schwab’s Core index funds, J.P. Morgan Asset Management’s BetaBuilders suite which offers a handful of broad market and country equity ETFs and a broad U.S. fixed income ETF, Invesco’s PureBeta funds and most of Vanguard’s ETF portfolio.
During the past year, investors have witnessed the launch of the first funds with zero management fees. Fidelity was the first to market, with the launch of four mutual funds with zero expense ratio in second half of 2018. On the ETF side, this was followed by the launch of zero or negative fee funds this year by relative newcomers to the ETF space, but only on a limited or temporary basis. Fintech startup SoFi recently launched the first two ETFs with zero fees, albeit on a temporary waiver of their standard 19 bp fees. Another startup, Salt Financial, also recently launched a “negative fee” ETF, meaning it effectively pays investors for holding onto the fund. However the -5 bp fee is only on the first $100 million in AUM and only until April 2020, after which the fee is due to revert to its standard +29 bps.
“We have yet to see an ETF charging zero fees for an indefinite timeframe, but a number of broad U.S. equity ETFs have come close: the recently launched J.P.Morgan BetaBuilders US Equity ETF charges just 2 bps, and several other funds charge 3-4 bps,” added Kolanovic and Kaplan.
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