the ETF phenomenon

To my mind, the ETF phenomenon is not just a story about price advantage.  I think the popularity of ETFs is an indicator of a fundamental sea change in sentiment on the part of individual investors.  For me,ETFs mark the end of the almost twenty-year love affair of individuals with actively managed mutual funds–and maybe with mutual funds, period–that began after the stock market crash in 1987.

Just as individuals shifted from relying on retail brokers to puting their faith in mutual fund portfolio managers after Black Monday, the trigger for the change in direction has been the Great Recession.  Its cause is the continuing failure of even the most highly publicized active managers to beat their benchmark indices-or, even if they did, to preserve during the downturn of 2007-2009 what their clients thought of as enough of their wealth.

The new trend is for individuals to take responsibility for themselves and to allocate their portfolios by sector through narrowly focused passive vehicles, that is, ETFs.

price war?  yes and no

Exchange traded funds, which now control over $1trillion in assets in the US, appear to be entering a new phase of competition, one marked by sharp reductions in their management fees.  The media are calling this a “price war.”

It’s not a price war in the most dramatic sense–where firms with excess production capacity slash selling prices in a desperate bid to keep their heads above water, or to generate cash flow needed to repay debt.  But it still is one, in the sense of a widespread fall in fee levels.

What do the fee reductions mean? 

Two aspects:

a maturing industry

1.  At one time, ETFs were competing for investor dollars primarily against their cousins, index mutual funds.

During this period, simply having an expense ratio lower that that of an index fund was all an ETF needed to succeed.  Today, despite the fact that their per share expenses are already far below those of index funds, ETF companies are beginning to slash their fees further.

(An aside:  to some extent, the ETF fee advantage is offset by the commission charges that ETF transactions bring with them.  More important, buyers pay more than net asset value at the time of purchase, sellers collect a bit less.  There isn’t enough data available for third parties to determine what this bid-asked spread typically amounts to.  Comparisons of ETFs vs. index funds usually deal with this issue by ignoring it, making ETFs look somewhat more attractive on a cost basis that then actually are.)

That’s because competition between ETFs and index funds is over.  Index funds have been defeated.  The new contest for customers is between one ETF and another.

closing the door to newcomers

2.  Investment products like mutual funds and ETFs have substantial up-front fixed costs, mostly computers and professionals to manage the money and safeguard it.  So they initially run at a loss.  Once a fund gets to the point where fees cover these costs, however, new assets bring almost pure profit.  Margins expand fast.

At some point high margins become a negative, not a positive.  They act as a lure for new competition.  And they allow new entrants to become profitable quickly.

Therefore, lowering fees has a second purpose.  It lengthens, possibly by an enormous amount, the time a potential new entrant must operate at a loss–and increases proportionally the amount of assets he must gather in order to reach profitability.  Naturally, this decreases the attractiveness of the industry to newcomers.  So, as counter-intuitive as it may seem, the fee reductions also serve to preserve the long-term profit profile of at least today’s very largest players.  It makes no economic sense for anyone else to enter the fray.

It’s interesting to note that of the three largest sellers of ETFs in the US, BlackRock, Vanguard and State Street, only Vanguard has a significant actively managed mutual fund complex.  All the other last-generation investment companies have had their heads in the sand.  Internal forces of the status quo have preferred to let assets leave rather than create an ETF divisions that might be headed by a political rival.