By Robert Goldsborough
One of the hottest topics in the exchange-traded fund world has been the ongoing price war that has continued driving costs down for investors.
The fee war has intensified in the last several years, as the ETF market has become more crowded. Some me-too products have come along with an eye toward undercutting a popular incumbent product, fee-wise. Offering the lowest fees in a product category has been a strategy for several entrants, with some incumbents responding with price cuts. Still other ETF providers have introduced other strategies or sought other ways of differentiating their products, such as asking investors to look at other indirect costs of holding an ETF beyond simply a stated expense ratio. And in recent years, brokerage platforms have partnered with ETF issuers to offer commission-free trading of select ETFs.
Outside the price wars, ETF fees can also change as assets under management rise and fall, and sometimes these changes are disclosed only in SEC filings.
In late December, Vanguard announced lower fees on 24 ETFs and higher fees on two funds. But because Vanguard has taken the position that it runs all of its ETFs (and mutual funds) at cost, the firm does not communicate lower expense ratios as price cuts per se. Instead, it simply notes that funds' expense ratios now are lower (or higher) because of changes in asset levels.
In iShares' case, about 40 ETFs saw their prospectus expense ratios rise by a few basis points each several weeks ago, which was also driven by changes in asset levels. This fee change was disclosed only in prospectuses filed with the SEC.
We would classify the more active cuts as outright industry warfare, aimed at growing market share, while one could view the smaller fee changes as more of a matter of scale and reflective of the industry's growth.
Even so, we don't believe that these ETF pricing decisions, proactive or not, occur in a vacuum. They unquestionably are being made with an eye toward the competitive set. What's more, it's pretty clear to us that the ETF fee war isn't going to be abating anytime soon. As the new year has begun, we thought it would be an appropriate time to review key points in the ETF price war.
State Street SPDRs: The Pioneers
The pioneer in the ETF space is State Street, which brought out the first-ever ETF, SPDR S&P 500 (SPY), in January 1993 at a price tag of 0.20%. Over the next eight years, the firm rounded out its early product portfolio with a host of ETFs, including more broad index ETFs, funds devoted to specific assets classes such as REITs, and the first-ever suite of U.S. equity sector ETFs. Expense-ratio reductions appeared almost immediately, and on a near-annual basis for some funds. For example, SPY cost 0.19% in 1995, 0.18% in 1996, and 0.17% in 1999. By 2004, its price tag was down to just 0.11%. Meanwhile, the Select Sector SPDR ETFs devoted to U.S. equities first charged what, by today's standards, seems excessive: 0.57%. Within two years, those equity sector ETFs' fees fell to 0.28%. By 2010, their price tags dropped to 0.20%.
iShares: The Blanket Strategy
In 1996, iShares rolled out its first ETFs--a suite of single-country, developed-, and emerging-markets funds. In 2000, iShares launched 14 more ETFs covering wide areas of the market, including U.S. large- and mid-cap exposures and some U.S. equity sectors. By 2003, the firm had moved into many other corners of the market, with a range of broad index funds both here and abroad, some bond ETFs, and the beginnings of a suite of equity sector funds. IShares' "blanket" strategy, which today encompasses some 280 ETFs and the industry’s dominant market share, involved going virtually everywhere rather than simply competing on cost.
Vanguard: Sticking to the Core
Vanguard entered the ETF business in 2001 with two core products: Vanguard Total Stock Market ETF (VTI) and Vanguard Extended Market Index ETF (VXF). Known for its low-priced, open-end index mutual funds, Vanguard began issuing ETF share classes of its mutual funds and fairly early on demonstrated a willingness to adjust its fees based on economies of scale from higher assets under management. By 2004, the firm had brought to market a variety of broad style ETFs and U.S. equity sector ETFs. The sector ETFs started out at a price of 0.28% and dropped in price to 0.24% by 2010.
Schwab Sets off the Price Wars
In 2009, Charles Schwab (SCHW) entered the ETF business and forged a new path with fees, charging just 0.08% for two of its four new ETFs: Schwab U.S. Broad Market ETF (SCHB) and Schwab U.S. Large-Cap ETF (SCHX). Those price tags were as low or lower than the fees for any other ETFs available at that time. Schwab's other two new funds, Schwab U.S. Small-Cap ETF (SCHA) and Schwab International Equity ETF (SCHF), cost just 0.14%. Also, Schwab began offering no commissions for existing Schwab customers who want to own these ETFs, a first in the industry. Subsequent ETFs rolled out in 2010 and 2011, including a low-cost REIT ETF at 0.13% and a low-cost mid-cap ETF also at 0.13%, followed this same model of being among the lowest-priced products in the space.
2010 and 2011: The War Intensifies
In September 2010, Vanguard launched nine new broad index ETFs. One of these, the firm’s long-awaited S&P 500 fund, Vanguard S&P 500 ETF (VOO), carried the fee of just 0.06%. That price tag was 3 basis points less than the fees charged at the time by peers iShares Core S&P 500 ETF (IVV) and SPDR S&P 500 (SPY), and brought it into a tie with Schwab U.S. Broad Market ETF (SCHB) for being the cheapest U.S. ETF at that time. Later that month, Vanguard rolled out seven new ETFs tracking broad Russell indexes with cheaper expense ratios than competing iShares ETFs that track the exact same indexes.
Another low-cost player came along in March 2011, when long-dormant ETF brand FocusShares made its return, launching 15 ETFs based on Morningstar indexes. (Morningstar licensed the indexes and earned asset-based fees.) FocusShares had sought to differentiate the ETFs most on price, with its broad-market and large-cap ETFs offering the lowest fees of any ETFs at that time--just 0.05%. What's more, its equity sector ETFs charged 0.19%--at that time, the lowest price for any equity sector ETF.
In December 2011, Vanguard cut its expense ratios on its U.S. equity sector ETFs by between 15% and 20%. That means that most of the funds' fees fell to 0.19% from 0.24%, with the historically higher-priced Vanguard Financials ETF's (VFH) price tag dropping to 0.23% from 0.27%. That 0.19% price tag struck many as no accident--it's just 1 basis point beneath the 0.20% that State Street was charging at that time for its SPDR equity sector ETFs. In addition, the price matched the fee that FocusShares was charging at that time for its equity sector ETFs.
The Rise of Commission-Free ETFs
After Schwab announced commission-free trading in 2009, a host of other brokerage platforms began offering similar deals. In February 2010, Fidelity began offering 25 iShares ETFs commission-free, while in May 2010, Vanguard started offering commission-free ETF trades for all of the company's ETFs. TD Ameritrade soon followed suit, announcing the waiving of trading fees in October 2010 on 101 ETFs.
In March 2011, several other brokerages soon got into the act. FocusShares parent Scottrade announced commission-free trades for the 15 FocusShares ETFs, while Interactive Brokers announced no commission fees for the five FactorShares ETFs trading at that time. The following month, Firstrade got into the act as well, offering 10 commission-free Vanguard, iShares, and PowerShares ETFs to its customers.
In late 2011, E-Trade became yet another broker offering commission-free ETF trades on 93 ETFs from three ETF providers: WisdomTree, Global X, and Deutsche Bank's db-X.
2012: The Volleys Continue
As 2012 began, State Street appeared to respond to Vanguard's December 2011 price cuts on its equity sector ETFs, slicing the investor fees for its nine popular U.S. equity sector ETFs to 0.18% from 0.20%. That brought the price tags of State Street's equity sector funds just 1 basis point below the fees at that time for the sector ETFs issued by FocusShares and Vanguard. Like Vanguard officials had insisted the previous month, State Street officials stated that they were not making the moves in response to the competitive landscape. Instead, they said, growing levels of assets allowed the price cuts to take place.
Soon afterward, Vanguard began cutting fees in a variety of ETF asset classes. In February 2012, Vanguard announced expense ratio reductions for six ETFs. The largest, Vanguard FTSE Emerging Markets ETF (VWO), saw its price tag fall to 0.20% from 0.22%. Also, the fee for Vanguard High Dividend Yield Indx ETF (VYM) dropped to 0.13% from 0.18%, making it one of the lowest-priced dividend ETFs available. In April 2012, Vanguard cut more ETF fees, albeit by slight amounts--just 1 or 2 basis points. The most notable change was the reduction of VOO's price from to 0.05% 0.06%, making it the single least expensive U.S. ETF at that time. Vanguard Total Bond Market ETF's (BND) price tag fell to 0.10% from 0.11%, and VTI's price dropped to 0.06% from 0.07%. Then, in May 2012, Vanguard reduced expense ratios for two more ETFs. The fee for Vanguard Dividend Appreciation ETF (VIG) dropped to 0.13% from 0.18%, while the cost to own Vanguard REIT Index ETF (VNQ) fell to 0.10% from 0.12%. Finally, Vanguard announced plans in October 2012 to switch benchmarks for 22 of its index ETFs and mutual funds as it aimed to reduce investor costs further.
In August 2012, in a move demonstrating that low ETF price tags don't guarantee asset inflows, FocusShares threw in the towel. After its suite of 15 low-cost ETFs gained little traction with investors, the firm closed, delisted, and liquidated all 15 of its funds.
Schwab continued placing pressure on ETF fees in 2012, announcing fee cuts in September 2012 on all 15 of its ETFs. Two of the ETFs immediately became the lowest-priced ETFs that trade: Schwab U.S. Broad Market ETF (SCHB) dropped its price tag to 0.04% from 0.06%, while Schwab U.S. Large-Cap ETF (SCHX) saw its expense ratio fall to 0.04% from 0.08%.
Amid all these volleys, iShares had watched its ETF market share erode. Still dominant, the firm's market share had fallen to 41% in November 2012 after being as high as 49% in April 2009. In response to this, BlackRock CEO Laurence Fink in September 2012 told investors that his firm planned to cut expense ratios of some of its iShares ETFs in the coming quarter. Then, the following month, iShares announced a dramatic new pricing strategy involving both reducing some ETFs' expense ratios meaningfully, rolling out other new funds, and segmenting its customer base into two buckets: a low-priced, "core series" of ETFs for long-term, buy-and-hold investors, and a suite of highly liquid, higher-priced ETFs for frequent traders. Several ETFs, such as iShares Core S&P Total US Stock Market ETF (ITOT) and iShares Core Total US Bond Market ETF (AGG), underwent name changes and experienced significant expense ratio reductions of more than 50%, while iShares Core S&P 500 ETF (IVV) got a slight name change and saw its expense ratio fall to 0.07% from 0.09%. Other new "core" ETFs included iShares Core MSCI Emerging Markets ETF (IEMG), whose 0.18% fee is a fraction of the popular and highly liquid iShares MSCI Emerging Markets Index (EEM), even though the two funds are very similar. In the end, the moves were a complicated way for iShares to respond to industry pressure to cut fees and forgo revenue on higher-priced, highly liquid funds. IShares chose to solve the problem largely by creating a new sub-brand of "core" ETFs that will compete directly with iShares' existing higher-priced ETFs--as well as with other low-cost providers.
At year-end, more fee cuts arrived. In late December, Vanguard announced expense-ratio reductions on 24 of its ETFs. Most of its U.S. equity sector ETFs' expense ratios dropped to 0.14% from 0.19%, making them easily the cheapest sector ETFs available. Many bond and mortgage-backed securities' ETFs also were affected. Two small mid-cap ETFs actually saw their fees rise slightly--the victims of negative operating leverage.
You've Come a Long Way, Baby
All along, the principal beneficiary of the ETF fee war has been the investor. As the various firms have battled over which fund offers the lowest price for an asset class--or, which firm markets the lowest-priced ETF, period--we believe that the unrelenting downward pressure on fees has been nothing but positive for cost-conscious investors.
And taking a look back at this time line, we see some pretty stark price changes. Today, the cheapest S&P 500 ETF, VOO, charges just 0.05%--just one fourth of SPY's debut price tag 20 years ago. The 0.14% fee for most of Vanguard's equity sector ETFs is less than one fourth of what State Street charged for the industry's first equity sector funds in 1998. And the 0.04% that Schwab now assesses for its U.S. broad market ETF is slightly more than one fourth of what Vanguard originally charged for its total stock market ETF, back in 2001.
What's next? In the next several years, we expect a variety of dynamics to continue to keep downward pressure on ETF expense ratios. As the industry grows, we expect fund providers to continue to share economies of scale with investors, resulting in lower investor fees. We also anticipate more proactive, competitively-driven fee reductions from fund providers seeking to grab the attention of investors. And we see cost pressures spreading to other areas of the value chain, with ETF issuers continuing to pursue ways to reduce index licensing fees--such as changing index providers or self-indexing--and we would also hope providers would share those savings with investors. Finally, fee pressures already have spread beyond broad index ETFs and equity sector and bond ETFs to non-plain vanilla ETFs, and we would expect that trend to continue.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.