Index fund fee war kicks off in earnest as actively managed fees rise
Although some actively managed mutual funds have reversed a decades-old trend and cut their fees in the last two years, index fund fees are falling off the table. Ironically, over the past couple of years, that most active of all mutual fund shops, Fidelity, has led the charge on reducing index fund expense ratios.
The index fund fee war reached fever pitch in August 2004, when Fidelity capped expense ratios on five of its index mutual funds at just ten basis points. The venerable mutual fund manager trumpeted the news with full broadsheet advertisements in the leading business papers announcing a "Perfect 10!"
E*Trade joined the battle in September, doing Fidelity one better by
lowering expense ratios on some of their index funds to just nine basis
points, a new record for a retail mutual fund. (In both cases, the fee
cuts were voluntary reductions. Fidelity has since made all of theirs,
save that of the Fidelity Spartan International (EAFE) Fund, permanent,
while E*Trade's expenses are still temporary reductions.)
The long-time index fund fee leader, The Vanguard Group, didn't respond
in kind. As the months ticked by, Vanguard appeared content to sit back
and watch the smaller index players battle it out for the title of
"Indexing Cost Leader." Vanguard has always made a very public point of
not getting drawn into competitive battles, and maintains that its fees
fall naturally as assets rise.
In the middle of March 2005, whether as a part of the natural process
or as a response, Vanguard roared back, rolling out significant fee
reductions across a broad swath of its funds and stealing the low-fee
mantle back from E*Trade. In a twist few expected, however, the company
shifted the fee battleground into the realm of exchange-traded funds
(ETFs).
While Vanguard dropped prices on a large number of products, the most
striking reductions centered on its family of VIPERs-branded ETFs:
Expense ratios on all 23 VIPERs were slashed by three-to-ten basis
points, depending on the fund. Moreover, the expense ratios for two
funds-the Vanguard Large Cap Index (NYSE: VV) and the Vanguard
Total Market Index (NYSE: VTI)-fell to just seven basis points, a new
record for retail mutual funds. (Under the Vanguard system, VIPERs
function as separate share classes of existing Vanguard funds.)
Economies Of Scale
According to Vanguard, the fee cuts were not a response to the indexing
fee war, but a natural consequence of the growth in ETF assets.
"The cut in expense ratios occurred because of the growth of assets in
the VIPERs program," says Gus Sauter, chief investment officer at
Vanguard. "Assets have tripled in the last few years, and that gives us
a broader base to defray fixed costs. As our funds increase in size, we
gain economies of scale."
And Vanguard has no choice but to pass those economies of scale on to
shareholders. As Sauter points out, Vanguard is owned by its
shareholders-it's effectively a mutual fund "co-op." And the rules of
that co-op state that Vanguard funds must be run on an "at-cost" basis.
In other words, the company must regularly review the costs and the
income derived from running its funds, and must work to make those two
figures match up.
That's great news for shareholders, because as VIPERs assets grow-and
all signs suggest that they will, rapidly-those costs will continue to
come down. In fact, Sauter says that over time the VIPERs would
probably become the lowest cost (or tied for the lowest cost) share
class at Vanguard.
"It's just a matter of how the product works," Sauter explains.
"Essentially, it's because the fund provider does not have to do
shareholder record keeping. In a conventional class, we might have
literally millions of shareholders that we have to do record keeping
for. In the VIPER class, there is only one shareholder-the trust."
The cost savings-from papers to mailings to sheer data entry-is
enormous. (Of course, it's not as if those costs disappear-they're
merely transferred to the brokerage firms. But that's a topic for
another article.)
Currently, VIPERs make up just a fraction of Vanguard's total assets-$7
billion out of $550 billion-but they're growing fast. Even during
January and February, when investors withdrew more than $4.5 billion
from ETFs industrywide, VIPERs assets grew by 16%. In March, however,
ETF inflows totaled $13 billion, with iShares pulling in $12 billion of
that money.
So a real battle for ETF product growth is shaping up, and Vanguard is
still a pup in the ETF arena-Barclay's Global Investors' iShares have
over $120 billion in assets and State Street Global Advisors
(SPDRs/streetTRACKS) has $67 billion. But a battle royale is shaping
up, pitting BGI's breadth of product and expert marketing against
SSgA's strong ETF brand and Vanguard's low cost and expert management.
It's nothing but good news for ETF investors, as prices come down and
the quality of product and availability of choices continue to rise.
Tax Overhang?
One widely expressed concern with the VIPERs is that, because they are
share classes of existing funds and not funds of their own, they will
not enjoy the tax efficiency of most ETFs. In fact, Gary Gastineau of
ETF Consultants argued this case persuasively in the May edition of the
Journal of Indexes. Gary points out, among other things, that VIPERs
shareholders inherit the unrealized capital gains of Vanguard's
long-running mutual funds.
Vanguard vigorously disagrees and, in fact, argues that VIPERs have a
tax advantage because of their unique share class structure.
"The tax comment is an interesting one since we haven't had any
distributions from our funds," says Sauter, when asked about the
capital gains overhang. "I remember back in the early 1990s when people
argued that we'd have nasty redemptions out of our funds if we
encountered a bear market. We always said that we'd sell the highest
costs lots and realize capital losses, and that's just what we did: We
ended up realizing $5 billion in capital losses, for instance, for our
Vanguard 500 fund, and almost $1 billion in our Total Stock Market
fund."
Sauter says that these realized losses are actually a benefit for
VIPERs shareholders. Of course, the capital gains overhang is still
there. The question is whether or not it will ever catch up with
Vanguard.
The Industry Responds ... Or Not
With fees falling across the indexing industry-and with ETFs now in
play-you might think that the more established players in the ETF
market would be thinking about lowering their own fees. After all,
although Vanguard is a relatively new and relatively small player in
the ETF arena-the company only launched its first ETF in 2001, and only
got serious about the business last year-you'd think that the prospect
of Vanguard pushing hard on ETFs would present a competitive threat to
the likes of Barclays and State Street.
If so, they're not letting on.
"We really haven't felt any pressure to respond on fees," says J.
Parsons, director of marketing at BGI. "People need to look at the
value of what they are receiving."
"We're pretty comfortable with our pricing," adds Gary Macdonald,
director of marketing at SSgA, in a separate interview. "We are a big
operation and we're used to competing in a cost-efficient environment,
so we're able to deliver economies of scale to our shareholders."
Both Macdonald and Parsons stress that there's more to an ETF than
costs, and that investors would be wise to look closely when they
select one ETF over another.
"Beyond costs, investors should really look at the underlying index.
That's especially true for sector ETFs, and even moreso for style
ETFs," says Macdonald. "For instance, there are some pretty important
differences between how each index family slices up the market into
growth and value."
Parsons echoes the importance of the benchmark and raised the specific
example of the iShares Emerging Markets fund (EEM). EEM is the leading
emerging markets ETF, with assets of $4.25 billion; it comes with an
expense ratio of 75 basis points. Vanguard recently debuted a new
emerging markets ETF with a 30 basis point expense ratio, pointing out
that it cost "less than half of comparable ETFs."
Parsons says that the expense ratios don't tell the whole story:
"Our Emerging Markets ETF includes eight more countries than the
Vanguard offering. The expense ratio is a little bit higher for the
iShare, but you get exposure to countries like Russia, Malaysia and
Pakistan."
Interesting.
Vanguard, for its part, didn't shy away from the importance of
benchmarks, with Sauter saying that investors should examine the
benchmarks carefully.
"They should also consider whether the portfolio manager does a good job matching that benchmark," he adds.
A Better Mousetrap
Whether or not the BGIs or SSgAs of the world cut prices on their ETFs today or tomorrow is almost beyond the point. Based on discussions with all of the major ETF providers, one thing is clear: ETF prices are low and they're going lower, especially as more assets flood into the funds.