By Virginia Munger Kahn

In the race to gather assets, exchange-traded fund sponsors are cutting prices to the bone. Today, there are nine ETFs in the market with expense ratios under 10 basis points and almost 80 priced at 15 basis points or less.

Several months ago, consulting giant McKinsey & Company warned ETF sponsors against igniting price wars because it says there isn't a clear-cut link between ETF price cuts and asset flows. But that hasn't stopped price competition. In February, State Street cut prices on nine sector SPDR ETFs by 10 percent, to 18 basis points. This, after Vanguard pared expenses on its sector ETFs by 15% to 20% in December.

What's driving this race to the bottom in expense ratios are new players like Charles Schwab and Scottrade's FocusShares ETF family, which look to add value to advisors and traders who use the firms' trading and custodial platforms. At the same time, established players like Vanguard and BlackRock's iShares unit are taking advantage of economies of scale to drive expenses lower.

For established players with large, index-based ETFs, slashing expense ratios makes good business sense because they've built a competitive advantage that makes it tough for new competitors to come into the market. Richard Romey, president of ETF Portfolio Partners, a registered investment advisor in Leawood, Kan., says a major Midwestern bank recently told him it was focused on developing ETFs in specialized areas because it was too difficult to compete in the index product space.

Indeed, many new players launch ETFs with more complex strategies that can command higher fees, says Loren Fox, senior research analyst at Strategic Insight.

Contrary to McKinsey's cautionary take on the subject, Morningstar data indicates there is a close relationship between cutting expense ratios and increasing asset flows--even if other factors come into play. For three years, cash flows into the Vanguard Total Bond Market ETF (BND) have outstripped flows into the iShares Barclays Aggregate Bond Fund (AGG). BND's expense ratio has fallen to 10 basis points in the last three years versus a steady 20 basis point expense ratio for AGG. Last year, BND overtook AGG in assets under management, and as of this year's first quarter BND had $15.3 billion in assets versus $14.7 billion for AGG.

Similarly, the well-known competitive battle between Vanguard MSCI Emerging Markets ETF (VWO), which has an expense ratio of 20 basis points versus 67 basis points for the iShares MSCI Emerging Markets Index Fund (EEM), ended with Vanguard winning the battle for assets. By the end of this year's first quarter, VWO had $54.2 billion in assets versus $39.7 billion for EEM, according to Morningstar.

Vanguard ETF strategist Joel Dickson cautions these competitive battles were more than just about price cuts. BND has had a lower expense ratio than AGG since it was introduced in 2007. Its success is part of the overall trend toward lower-cost investing as well as Vanguard's increased profile in the advisor channel, he says.

Moreover, the battle over assets for emerging market ETFs was waged as much over index tracking error as price cuts, he asserts. Still, he adds, "being able to access a diversified portfolio of emerging market equities for 20 basis points is pretty compelling."  

It's More Than Price
When it comes to new players, though, rock-bottom expense ratios are not enough to overcome other factors important for attracting investment flows. Among them, says Fox from Strategic Insight, is the need for ETF sponsors to establish credibility with tracking error, trading costs and liquidity.

Take the FocusShares ETFs, for example. Despite their low expense ratio--the firm boasts the two cheapest ETFs on the market with expense ratios of five basis points each--and their use of Morningstar indexes as their benchmark, this remains a tiny fund complex with just $100 million in assets spread across its 15 ETFs, all of which were launched on March 31, 2011.

One reason for the low flows is because the firm hasn't marketed the ETFs to customers beyond its Scottrade clientele. (Last month, Scottrade announced a national marketing campaign aimed at investment advisors.)

Another reason relates to trading costs associated with small ETFs. In early April, the bid/ask spread on the Focus Morningstar US Market ETF (FMU), which has an expense ratio of five basis points and $17.4 million in assets, ranged between 11 and 23 basis points.

By contrast, the bid/ask spread for the Vanguard Total Stock Market ETF (VTI) remained around one basis point. VTI has an expense ratio of seven basis points and $21.4 billion in assets. "You can wipe out the expense ratio savings with one bad trade," says Morningstar ETF analyst Michael Rawson.  

Low Prices . . . At What Cost To Sponsors?
Being first-to-market, coupled with investor inertia, can also affect cash flows. While saving a few basis points a year in expenses can add up to a lot of money, investors often are unwilling to trade into slightly cheaper ETFs because of tax consequences and transaction costs, says Romey from ETF Portfolio Partners.

While the connection between price cuts and cash flows is not perfect, analysts and industry executives have little doubt price competition will remain intense. As long as the markets are healthy, established players will benefit from increasing economies of scale and new players will look to garner investor assets with competitive pricing.

Of course, that says nothing about the long-term viability of these ETFs. The lower that expense ratios go, the higher assets have to climb to cover costs and generate profits. "There are perhaps hundreds of ETFs out there that are not viable because of their assets under management and their cost structure," says Jeff Tjornehoj, senior research analyst at Lipper. "You have to pay for that growth at some point."