How Fee Compression Is a Blessing and a Curse for ETF Managers

Over the past decade, just three exchange-traded fund (ETF) issuers in the U.S. have captured the bulk of all net U.S. ETF inflows. These three – BlackRock, Inc. (BLK), Vanguard, and The Charles Schwab Corporation (SCHW) – have also been competing with each other on fees. Amongst all ETFs, the combined asset-weighted average ETF expense ratios have fallen to just 0.45% in 2019, down from 0.87% twenty years earlier, a fee compression of nearly fifty percent, or 2.5% per year, on average.

Below, we'll explore some of the reasons why this fee compression can be both good and bad for the space overall.

A Closer Look at the Top Three

Among the top three U.S. ETF issuers, it is clear that expense ratios vary wildly among ETFs.

• Vanguard, which has captured around one-third of ETF assets, has an average expense ratio of 0.09% on an asset-weighted basis.
• Charles Schwab, which brought in 13% of flows despite controlling just 3% of the total assets at the beginning of the year, also now has an average fee of 0.09%.
• BlackRock/iShares actually lost market share recently; falling from around 40% to one-third of new net ETF flows. Part of the reason for this is the fact that BlackRock's average expense ratio is 0.27%, although this is due to more actively-managed and leveraged ETFs among iShares offerings.

Declines in the asset-weighted average fees were the largest among passively managed index funds thanks to strong flows. In aggregate, passively managed ETFs exhibited asset-weighted expense ratio declines of 8% from 2018. Municipal bond ETFs, in particular, exhibited the largest declines among passive funds, with their asset-weighted average fees falling 27% to reach a new low of 0.17%. This dramatic decline resulted, in part, from fee cuts among some of the largest funds in the category.

Specifically, BlackRock's iShares National Muni Bond ETF (MUB) more than halved its fee to 0.11% from 0.25%. And Vanguard Tax-Exempt Bond ETF (VTEB) reduced its fee to 0.06% from the already modest 0.08%.

Potential Issues With Fee Compression

As expense ratios get lower and lower, ETF managers may feel the squeeze in certain areas. Investors today increasingly expect that portfolio management will essentially be free of charge. ETFs that could have previously maintained market share by offering greater liquidity are now struggling to compete with cheaper rivals. With investor money continuing to flow primarily to those ETFs seen as the best value, there is increasing pressure for all players to lower their fees and cut costs.

According to a recent report by ETF.com, in the U.S. ETF space in 2020, those products gaining market share within their segments tend to cost under 0.20% on an asset-weighted basis; meanwhile, those ETFs losing market share cost more than 0.25%. As the report suggests, "every basis point in expense ratio increases the risk of irrelevance or failure, unless there is no competition in that particular space."

As a result, some once-popular ETFs can no longer rely on filling a market niche. As soon as cheaper competitors enter the market, it becomes a race to the bottom in terms of fees. One of the most popular ETFs, the SPDR S&P 500 ETF Trust (SPY), has actually lost more than $21 billion in assets during the first half of the year, with many of those assets going toward cheaper S&P 500 ETF competitors. Whether the quality of these competitors is on par with the SPDRs, the ETF series that started it all, is to be seen.

Benefits of Fee Compression

The benefits of fee compression may seem to be heavily weighted toward the investor. Indeed, investors have never before had so many low-cost options to gain access to diversified portfolios with both passive and active strategies.

However, low fees across the ETF space have also helped the industry to grow as quickly as it has. In comparison with mutual funds and other actively managed products, ETFs offer much more attractive fees as a group.

The Bottom Line

ETF fees have been steadily falling as ETF providers compete with one other for assets. However, what began as a draw for the ETF space relative to other types of products may have come back to bite fund managers. Investors continue to press ETFs to lower their fees, and it seems likely that expense ratios will eventually be driven down to zero, or at least to the lowest possible level to cover operating costs.