Exploring falling ETF costs: ETF Perspectives

July 10, 2019

 
Rich Powers

Rich Powers
Head of Vanguard ETF Product Management

(hint: not just expense ratios)

A little over 15 years ago, The Da Vinci Code1 topped best-seller lists for months, and eager readers paid more than $20 to grab a copy. Now, brand-new books at the top of the best-seller list can be had for around $16. How can this be, with 15 years of inflation in everything from a ticket to the movies to college tuition? The answer: It's because of e-commerce—a disrupting force that has lowered the cost of basic consumer goods throughout the value chain.

In many ways, the growth of ETFs has accomplished the same for investors.

On the surface, we all know "sticker price" expense ratios are lower, but so are a host of other costs implicit in the "investing value chain." Let's take a moment to really consider the three biggest reasons that, all else being equal, the rise of ETFs has led to more money in the pockets of investors—just as e-commerce has led to a bit more cash in consumers' wallets.

Lower expense ratios

Expense ratios are the headline cost that everyone talks about; respected surveys indicate advisors consider expense ratios to be paramount among a variety of criteria when choosing ETFs. And it's no secret that ETF expense ratios are low, especially relative to those of active mutual funds, so we won't spend much time rehashing.

But you may wonder how exactly ETF expense ratios can be so low.

Three reasons ETF expense ratios are low:

  • Flows of funds to lower-cost ETFs far outweigh flows to higher-cost ETFs, so the business strategy for many firms has been to lower costs where they can. Given the large asset growth of ETFs, particularly relative to the relatively stable fixed management costs, many managers have been able to leverage economies of scale to lower expense ratios.
  • It's partly due to most ETFs being run as index funds, which cost less to manage than active funds.
  • Falling costs are also partly due to the fact that it’s less costly to distribute ETFs than mutual funds, since they’re available to buy and sell on almost any brokerage platform.

Five-year comparison of asset-weighted expenses

Five-year comparison of asset-weighted expenses

Source: Morningstar, Inc.

The graph above shows the dollars paid to all investment managers relative to all the assets invested in funds and ETFs five years ago versus 2018. As you can see, fund managers are taking home less of the pie than they used to. A big reason for that is the growth of ETFs, which are lower-cost and have grown in popularity at the expense of higher-cost funds.

Narrowing spreads

Investors in ETFs "pay their own way" when they buy or sell their positions in the form of bid-ask spreads. As ETFs have grown in assets and trading volume, spreads in the aggregate have narrowed. This means lower transaction costs, with increased economic value accruing to investors—instead of to ETF market makers, who facilitate trading in ETFs.

We're frequently asked how to think about the spread as a cost, and it's a fair question since it's not an explicit cost, like an expense ratio. But the bid-ask spread represents an implicit cost.

For example, a seller may be willing to part ways with his or her ETF shares for, say, $100.05 a share, but you may only be able to actually buy a share in the market for $100.08. In this case, the $0.03 difference is compensation to the market maker for taking on the risk to facilitate the transaction.

While you couldn't have actually bought a share for $100.05 without the market maker, it's still a foregone economic value. But as I mentioned, spreads are falling.

Reasons for declining spreads:

  • The more shares that are traded, the easier it is for market makers to cover their risk. This reduction of operational risk and increased competition leads to tighter spreads.
  • Improving technology helps market makers interact in faster and more accurate ways with ETF managers. This is perhaps most evident for fixed income ETFs over the last few years, as shown to the right.

Fixed income ETF notional volume and spreads, 2013–2015

Fixed income ETF notional volume and spreads, 2013-201

Source: Bloomberg.

Disappearing commissions

A very explicit out-of-pocket cost to ETF investors is the commission paid to the brokerage executing the trade. This cost has been relatively modest historically—think about $10 per trade, no matter the size. But it has been persistent, and it is conspicuous to clients.

Commissions can also add up when rebalancing or dollar-cost averaging. But as ETFs have risen in popularity, some of the largest brokerage platforms have reduced or eliminated commissions dramatically in an effort to win more investors to their platforms.

The takeaway is, of course, that lower commissions benefit all investors.

Low-cost trend, the investor’s friend

We've dug into the nitty-gritty on how three meaningful costs have fallen as ETF assets have risen. We could spend more time detailing additional ways ETFs have lowered costs, such as through the potential for lower taxes (in-kind redemptions) and the reduced fund-management transaction costs that go with indexing because it is generally a low-turnover strategy.

That said, the story is simple: The ETF vehicle, and its powerful role in democratizing indexing as a strategy, has chipped away at costs all along the "value chain." Fund managers, market makers, sell-side traders, and brokerage platforms each are increasingly taking less these days, and investors are keeping more than they might have if ETFs hadn't entered the picture.

1 Dan Brown, 2003. The Da Vinci Code: New York, N.Y.: Doubleday.

Notes:

  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • Diversification does not ensure a profit or protect against a loss.
  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
  • Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
  • Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from the stock market. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.
  • Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment, and that transaction costs could offset the tax benefit. There may also be unintended tax implications. We recommend that you consult a tax advisor before taking action.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

 

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