The ETF fee war is great for investors, saving them millions of dollars, but it’s created a headwind for traditional active managers that’s expected to intensify.
This month alone has seen two entrants into the exchange-traded funds marketplace that could radically change the fee equation across the industry, putting ever more revenue pressure on traditional managers, who have been struggling to retain assets amid a broader shift to low-fee index funds.
At the start of the month, the GraniteShares Gold Trust BAR, -0.75% was launched with an expense ratio of 0.2%, or $20 for every $10,000 invested. That’s half the fee charged by the SPDR Gold Shares ETF GLD, -0.75% by far the biggest gold fund on the market, and it also undercut the 0.25% charged by the iShares Gold Trust IAU, -0.70%
The market for U.S.-listed commodity-based ETFs isn’t huge—it has about $70 billion in assets, according to FactSet data, compared with nearly $2.5 trillion in equity funds—so that particular case may only have a limited impact. On Monday, however, Goldman Sachs filed for an equally weighted S&P 500 SPX, +0.08% fund that only costs 0.09%, dramatically lower than the Guggenheim S&P 500 Equal Weight ETF RSP, +0.01% the current leader of that category, which goes for 0.2%.
Goldman’s “move expands the ETF price war beyond plain vanilla ETFs into smart-beta ETFs, implying that the industry’s higher pricing assumptions for smart-beta products will not hold,” wrote Stephen Tu, a senior analyst at Moody’s, in a Monday note. He added that the smart beta price war was a credit negative for traditional active equity managers.
“Smart beta” is a category of ETF that sits midway between passive funds—which track an index like the S&P, holding what it does, and in the same proportion—and active funds, where the holdings are individually selected by a portfolio manager. While these funds, also known as “strategic beta,” do track an index, the components of many are not weighted by their market capitalization, and they are designed to do better than the traditional index over time. The indexes tracked by smart-beta funds are developed through rules that tilt toward such strategies as “value” or “growth.”
Tu noted that traditional active managers, such as Legg Mason LM, -0.92% Franklin Resources BEN, -0.47% and Janus JHG, -2.82% have seen “steadily declining market share” as a result of the move to passive funds. According to Morningstar, active funds saw outflows of $285.2 billion in 2016; passive funds attracted inflows of $428.7 billion.
To combat this, such managers have been investing in smart-beta products, which they viewed as “a product category with which they could grow assets without too much sacrifice on revenue,” Tu wrote.
Goldman’s aggressively low fee could change that equation. Currently, most smart-beta products have been priced between 0.24% and 0.39%, a pricing range that at the high end is more than four times more expensive than Goldman’s proposed fund.
Currently, the 100 largest smart-beta funds have an average expense ratio of 0.27%, although this is heavily impacted by Vanguard, which has been the big winner of the shift to passive funds and other low-fee products. Excluding Vanguard, the average ratio for the largest 100 funds is 0.33%.
“The plain vanilla ETF category has experienced a severe price war in which products pricing has migrated toward zero basis points, and this aggressive price competition is migrating up toward the smart-beta category,” Tu wrote. “As a result, much of the hope and investment traditional managers placed into smart beta as a product salvation may be at risk. This is negative for traditional active managers that move into this space and expect to charge active light management fees, but will rather face a more index-like pricing environment.”
While investors don’t care about fees to the exclusion of all other factors—for example, tracking error, tradability, and liquidity—the dominant trend in recent years has been to the cheapest funds on the market. According to data from Bloomberg, ETFs that charge between 0% and 0.1% have had inflows of nearly $250 billion thus far this year (through the end of August). Funds charging between 0.21% and 0.3% have seen inflows of less than $25 billion.
According to the Investment Company Institute, expense ratios for U.S. equity ETFs overall dropped by nearly a third between 2009 and 2016, falling 32% to 23 basis points (or 0.23% of assets) on average, from 34 basis points. In June, Morgan Stanley estimated that fees could fall an additional 10% to 15% over the coming three to five years.
Moody’s currently rates Legg Mason as Baa1 negative, Franklin as A1 negative and Janus as Baa3 positive. Tu also said that falling smart-beta fees would be a negative for existing managers in the space, “which are likely to respond with price cuts on existing products.”
Among those, Invesco Ltd. IVZ, +0.68% is rated A2 stable while both BlackRock Inc. BLK, -0.71% and State Street Corp. STT, -0.73% are rated A1 positive. BlackRock operates the iShares suite of products and has the largest market share of the ETF space. State Street sponsors the SPDR family of funds, which includes the SPDR S&P 500 ETF Trust SPY, +0.05% the oldest and largest ETF on the market.