ETF fees: How low can they go?

“The fee cuts have appeal across the board. And for fee-based advisors, they offer more scope for lowering the pricing of their advice-giving services,” says Rudy Luukko, investment funds and personal finance editor with Toronto-based Morningstar Canada. “They’re increasing the competition, not only in the ETF industry but for traditional, open-end mutual funds, particularly in the fee-based advisory sector.”

The strategy of the ETF providers is to increase sales and market share by enticing investors with lower fees on core ETFs and ultimately creating economies of scale. Although fee competition is a boon to investors, it must prove to be a viable business strategy for providers rather than simply igniting a race to the bottom.

“The margins, in some cases, are quite thin after the recent cuts,” says Pat Chiefalo, director of derivatives and structured products at National Bank Financial Inc. in Toronto. “The goal is to offer a suite of products where the important factor is the fee. The providers feel it makes economic and business sense.”

The fee battle intensified earlier this year, when iShares chopped fees on its iShares Core Series, which include two domestic equity, four foreign equity and three fixed-income ETFs, after the firm suffered through a period of overall net redemptions. With $44 billion in assets under management (AUM) in 95 ETFs, iShares is the industry leader in Canada in terms of AUM.

Some of the more significant fee reductions include a drop of 35 basis points (bps) in the management fee for iShares S&P/TSX Equity Income Index ETF to 20 bps; a 35-bps drop in fees for iShares MSCI Emerging Markets IMI Index to 25 bps; a four-bps drop in the fee for iShares S&P 500 Index ETF to 10 bps; and the CAD-hedged version’s fee dropped by 12 bps to 10 bps, essentially removing any extra cost for currency protection.

“Our selection of funds for the Core Series,” says Noel Archard, managing director of BlackRock Canada, “allows investors to build diversified global portfolios across various asset classes, using broadly based products.”

Archard says the fee cuts appeal to both retail and institutional investors, as well as to the new breed of ETF portfolio strategists who use “passively managed ETFs in their actively managed asset-allocation strategies” to achieve diversified exposures to various asset classes around the world.

The new Core Series, he adds, accounted for 65% of new iShares AUM during the two months after its March launch – providing the industry’s largest ETF, iShares S&P/TSX Index ETF (trading symbol: XIU), is excluded from the calculation because of its exceptional popularity as a highly liquid, institutional capital markets tool.

Client behaviour will dictate if iShares adds more to the Core Series, Archard says, but the current stable of nine ETFs covers 80% of the territory in which Canadians are investing.

However, iShares did not reduce fees on XIU, which has about $12.4 billion in AUM. XIU’s management fee remains 15 bps per year, triple the fee charged by the broader iShares S&P/TSX Capped Composite Index ETF (XIC), which has $1.4 billion in AUM and previously charged 25 bps before the March fee reduction.

XIC offers wider exposure – about 250 names across a range of market capitalizations – compared to the 60 large companies represented in XIU, but for a lower fee.

About a month after the iShares fee cuts, BMO Asset Management announced fee reductions on seven of its 58 ETFs, including six equity ETFs and one fixed-income ETF, in its $13-billion family of ETFs. Among those, BMO S&P/TSX Capped Composite Index ETF (ZCN), which provides exposure to the broad Canadian market equivalent to that of XIC, saw its fee chopped by 10 bps to match XIC at 5 bps. Other cuts announced by BMO bring its ETFs in line with similar ETFs offered by iShares.

“The game has changed among Canadian ETF providers,” says Mark Raes, vice president and head of product, BMO exchange-traded funds, with BMO. “And that’s a huge benefit for the end-users of the product.”

These newly discounted ETFs are “out-Vanguarding” Vanguard Canada, says Luukko, the Canadian arm of the U.S.-based fund giant that has established a reputation as being a low-fee provider.

Atul Tiwari, managing director of Vanguard Canada, says the average weighted management fee across all AUM in Vanguard’s 16 ETFs as of June 30 was 19 bps, while the average weighted fee for competitors among the nine other ETF providers in Canada ranged from 30 bps to 81 bps. Since then, Vanguard Canada has expanded its lineup to 21 ETFs.

“We are still the low-fee provider in the industry, and our business model is set up to drive costs down as scale grows,” Tiwari says. “After we enter a market, initially and over time, our competitors tend to reduce fees on selected products in an attempt to compete and gain market share. We expect it. But there’s the question of how low can they go. At some point, it’s counterproductive.”

ETF providers are taking a targeted approach to competing on fees, Luukko says, rather than slashing across the board. Recent fee cuts are focusing on ETFs tied to the broad, market capitalization-weighted indices that essentially have become a commodity in the ETF business and where fees are the primary differentiator.

Many other ETFs offered by BlackRock, BMO and Horizons, as well as those by other competitors in the industry, offer “intelligent indexing” (a.k.a. “smart beta”) strategies that involve customized indices or more actively managed securities portfolios underlying the ETFs, which have higher fees to reflect the higher level of active management. The goal of these ETFs is to beat the market, not merely to match it.

“If you’re adding value in different ways,” says Raes, “such as providing exposure to specific sectors or industries, or offering alternative weighting strategies to the traditional market-cap indices, fees are less important.”

However, even with low-fee ETFs, there may be other differentiators besides price. Horizons S&P/TSX 60 Index ETF, for example, uses a total-return swap structure to provide a return equal to the underlying index rather than holding the individual securities.

This results in tax savings to investors due to lower turnover and rebalancing costs, and the fact that any dividend income from the index’s underlying stocks is added to the net asset value of the ETF units rather than being distributed to investors as taxable dividends.

“Price is just one component of ETFs; you can’t compete on price alone,” Horizons CEO Howard Atkinson says. “The tax benefit of the swap structure is worth 10 times the fee, but it all helps.”

Chiefalo says his firm has made some shifts in its model ETF portfolios based on the recent fee reductions. The firm’s Low Cost Global Balanced ETF portfolio of 14 ETFs, for example, now has a weighted average MER of only 14 bps. That portfolio currently holds 53% of its AUM in equity ETFs, 41% in bonds, 5% in alternative investments such as gold and 1% in cash.

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