ETF Investors Are Embracing Low Cost Options…Or Are They?

by on January 24, 2011 | ETFs Mentioned:

When running down the benefits of constructing a portfolio with ETFs, most investors will touch on the potential for enhanced tax efficiency, intra-day liquidity, and transparency in holdings. But the biggest benefit, in the minds of those accustomed to using primarily actively-managed mutual funds, are the low expense ratios. Most passively-indexed ETFs charge fees equal to only a fraction of the expense ratios levied by actively-managed products, making them ideal securities for investors convinced by the boatloads of academic evidence suggesting that active management fails to add value over the long term.

Some investors making the switch assume that any ETF they buy will be considerably cheaper than a comparable actively-managed mutual fund, and pat themselves on the back for lowering their overall expenses. But as more and more ETF investors are realizing, all ETFs are not created equal from an expense perspective, and the gap between many similar or even identical products is wide enough to drive a truck through [see the list of the 25 Cheapest ETFs].

In the mutual fund world, fund companies often compete on the basis of performance–highlighting star ratings or performance relative to a benchmark is the most common (and most effective) way to appeal to investors. In the ETF world, where the vast majority of products are passively indexed, fund sponsors have been forced to find other ways to differentiate their product lines. When considering multiple exchange-traded products within the same asset class or investment strategy, there are a limited number of metrics that investors can easily compare head-to-head.

The expense ratio is one metric that issuers can use to differentiate their products, and the last year or so has seen several firms change their fee structures in an effort to gain market share. Knowing that ETF investors are generally a cost-conscious crowd, it follows logically that when picking between comparable options, the cheapest fund would attract the most assets. And there is some support for the theory that the cheapest ETFs will ultimately become the biggest ETFs. But there are also some real life examples that seemingly throw a wrench into that argument as well [see ETF Price Wars Escalate].

Cheap ETFs Picking Up Steam

Measuring the impact that expenses have on an ETF’s success can be a tricky task. Though the fees charged are certainly one aspect considered by investors, there are other issues to address as well, such as weighting methodology, degree of diversification, trading volume, etc. While there are now more than 1,100 ETPs available to U.S. investors, the tremendous expansion of the product lineup in recent years has been driven primarily by innovation, not duplication. That means that there are very few “duplicate” ETFs that are identical in terms of underlying index but different in cost. There are a handful, however, and a closer look at these head-to-head ETF match-ups shows some interesting trends [see Five Ways To Slash Your ETF Expenses].

Gold ETFs: IAU vs. GLD

Effective July 1, 2010, iShares cut the expense ratio on its physically-backed gold ETF (IAU) from 0.40% to 0.25%. That made the fund materially cheaper than the SPDR Gold Trust (GLD), which charges 0.40% and had more than $52 billion at the end of June 2010. In the six months following the price cut, IAU saw cash inflows of $1.4 billion while GLD experienced outflows of almost $1.5 billion. During the 18 months prior to the price cut, GLD’s inflows had totaled more than $21 billion–about 33 times the inflows to to IAU (about $630 million). While IAU’s assets are only a fraction the size of the Gold SPDR, it seems as if the tide has turned and that investors seeking exposure to gold have embraced the lower cost option [also see Gold Bullion ETFs 101].

Emerging Markets ETFs: EEM vs. VWO

Perhaps the most interesting battle for market share has taken place between two ETFs that replicate the MSCI Emerging Markets Index: Vanguard’s VWO and iShares’ EEM. EEM debuted in 2003, and quickly became the most popular ETF option for investors seeking broad-based exposure to emerging markets. VWO launched two years later, boasting a considerably lower expense ratio (0.27%) than EEM (recently reduced from 0.72% to 0.69%).

ETF 2008 Inflows 2009 Inflows 2010 Inflows
EEM $5,082 $4,957 $2,274
VWO $3,784 $8,966 19,281
Source: NSX. $ in millions

Despite the huge gains made by VWO, the Vanguard ETF was still smaller than EEM at the end of the year; in the last week it has finally eclipsed its more expensive competitor in terms of assets under management.

Total Bond Market ETFs: AGG vs. BND

There are currently 12 ETFs in the Total Bond Market ETFdb Category, with aggregate assets of almost $30 billion. The majority of these assets are in two funds linked to the broad-based Barclays Capital U.S. Aggregate Bond Index: Vanguard’s BND and iShares’ AGG. Again, the iShares product was on the market first (AGG launched in 2003, BND debuted in 2007). And again, the Vanguard fund is cheaper, charging 12 basis points compared to 24 for AGG.

A similar story is playing out in this head-to-head battle as well; AGG remains the largest total bond market ETF, but the low cost alternative is quickly gaining ground:

ETF 2008 Inflows 2009 Inflows 2010 Inflows
AGG $1,665 $1,610 ($297)
BND $1,816 $3,211 $2,669
Source: NSX. $ in millions

Underappreciated Bargains

The three cases outlined above would suggest that ETF investors are very cost conscious, and that they are gravitating towards the cheapest options to accomplish their investment objectives. But there is some evidence to the contrary as well; a low expense ratio is clearly not enough to ensure an ETF’s success.

DJP vs. DJCI

The iPath Dow Jones-UBS Commodity ETN (DJP) is one of the most popular broad-based commodity ETPs with nearly $3 billion in assets. The ETN is linked to the Dow Jones-UBS Commodity Index Total Return, a futures-based benchmark that offers exposure to about 10 different resources. With an expense ratio of 0.75%, DJP is 50% more expensive than the Dow-Jones UBS Commodity Index ETN from UBS (DJCI), which charges just 50 basis points. Somewhat surprisingly, however, DJCI has just about $25 million in assets–or less than 1% of DJP’s AUM. For whatever reason, investors haven’t taken advantage of the opportunity to make a free 25 bps.

LAG

Above we highlighted the Vanguard Total Bond Market ETF (BND) as an increasingly popular broad-based bond fund. But among funds seeking to replicate the Barclays Capital U.S. Aggregate Bond Index, BND isn’t the cheapest option; that honor belongs to State Street’s LAG, which charges just 0.1345%. And just how has that cost advantage worked out for this SPDR? More than three years after launch, LAG has about $220 million in assets–about 1% of the aggregate assets in the more expensive AGG and BND [also read For ETF Investors, The Details Matter].

GlobalShares’ Fiasco

In May of last year, GlobalShares cut the expense ratio on its FTSE Emerging Markets Fund (GSR) from 0.35% to 0.25%, making it the cheapest in the Emerging Markets ETFdb Category. Previously, GlobalShares had waived the entire management fee for GSR, offering the fund with a temporary expense ratio of 0.0%. But those steps failed to generate much interest; when GlobalShares announced at the end of September that it was pulling out of the U.S. ETF industry, GSR had a whopping $4 million in year-to-date cash inflows.

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Disclosure: No positions at time of writing.