Updated Friday, July 25, 2014 as of 9:08 PM ET
Portfolio - ETFs
ETF Fee Smackdown
Thursday, December 6, 2012
Partner Insights

Not too long ago, there was an obvious way to construct a broad, low-cost ETF portfolio for clients: Turn to Vanguard. Then Schwab and iShares entered the fray -- possibly because Vanguard was collecting 32.4% of all new investor money into ETFs. One of the two giants lowered expense ratios; the other launched new ETFs to compete with Vanguard. Although the fee war has been great for clients, selecting the right ETFs isn’t just about expense ratios. Here’s what you need to know.

Schwab’s Gambit

Schwab made the first move in September when it filed with the SEC to lower the expense ratios of its ETFs dramatically. Suddenly, Vanguard no longer had the lowest expense ratios for diversified stock and bond portfolios. Schwab’s new annual expense ratio for the U.S. broad market fund (SCHB) is only 0.04%, for instance, besting Vanguard’s 0.06%. Its international index fund (SCHF) expense ratio of 0.09% is also lower than Vanguard’s, while the Schwab U.S. aggregate bond market ETF (SCHZ) expense ratio of 0.05% is half Vanguard’s 0.1% expense ratio.

It was a bold competitive move. At the time, Schwab had only $7.5 billion in ETF assets -- a far cry from Vanguard’s $221 billion in ETF assets (and $645 billion in all index asset classes).
And it could be tricky for Vanguard to respond. Vanguard’s ETFs and mutual funds are different share classes of the same fund. So for Vanguard to match Schwab’s new fees would be extremely costly, as they would likely have to do it for an asset base nearly 100 times larger than Schwab’s. Although critics speculated that Schwab was using its ETFs as a loss leader, Schwab’s managing director of ETFs, Eric Pollackov, denied it; he said the company is committed to low-cost ETF investing and expects its ETF businesses to be profitable.

In October, Vanguard announced its own initiative to lower expense ratios over the longer term by switching target benchmarks on 22 index funds to CRSP from MSCI. The lower licensing fees will allow Vanguard to pass the savings through to fund shareholders.
All that wrangling left a dilemma for BlackRock’s iShares, the largest provider of ETFs (with a half-trillion dollars under management), which had already been losing share to Vanguard. Lowering fees to match would cost BlackRock $259 million annually, according to Matt Hougan, president of ETF analytics at IndexUniverse. Yet if iShares left fees intact, the company would keep losing share.

BlackRock’s response was to launch new ETFs known as core ETFs to compete with Vanguard and Schwab. The iShares Core ETFs are marketed to buy-and-hold investors, and generally matched Vanguard’s expense ratio -- a bit higher in equities and lower in fixed income. That solved BlackRock’s problems but shifted the challenge to advisors and consumers. To get the lower expense ratios, advisors would need to sell clients’ existing iShares ETFs, possibly triggering capital gains.

The upshot: In a remarkably short period, the playing field for the lowest-cost ETFs has changed dramatically. (Notably, State Street, the second-largest ETF provider has remained on the sidelines.) The winners, of course, are clients; the lower fees will result in higher returns. Below is a snapshot of the current playing field of the broadest ETFs.

If expense ratios were the only factor in fund selection, there wouldn’t be much more to say, and Schwab would be the easy choice. But other issues are perhaps even more important. One key consideration is how an index fund is constructed. For example, Vanguard and iShares international index funds include developed and emerging markets, as well as
large-, mid- and small-cap companies. But the Schwab international index fund only includes developed countries and leaves out small-cap companies.

Another factor is costs, including the bid/ask spreads as well as premiums and discounts paid in buying and selling. These costs are often many times the annual expense ratio of these low- cost funds. There is also the question of tracking error -- how well the funds deliver the index returns. Smaller funds, for instance, must do more “optimization.” That’s another word for sampling -- which, of course, brings sampling error.

IndexUniverse’s ETF Analytics Tool looks at these factors and assigns an overall score, as well as a score for every fund by factor: efficiency (fund construction), tradability (cost to buy and sell) and fit (measures tracking). Here’s the analysis for each category.

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