Exchange-traded funds are the hot-ticket item these days. Very few products have grown as quickly or been as successful as ETFs. According to data from the Investment Company Institute, investment in ETFs rose to more than $1 trillion by the end of 2011, way up from $83bn in 2001. Meanwhile, the net decline for mutual funds was $546bn over the past three years.

Why are ETFs so popular? Mainly because they offer a more affordable option to high-cost mutual funds. According to The New York Times:

“Total expenses, including management fees and costs for marketing, trading and legal and regulatory compliance, are 1.26 percent for the average actively managed mutual fund. For index mutual funds, the corresponding figure is 0.99 percent, while the average ETF is run for just 0.57 percent of assets.”

Because high fees have typically been the Achilles’ heel of the mutual fund industry, investors are flocking to the cheaper ETFs.

The New York Times quoted Christian Magoon, CEO of Magoon Capital, as saying:

“This is a very dynamic time in the asset management space. ETFs are a disruptive technology similar to the digitalization of music. ETFs are disrupting mutual fund vehicles.”

Three firms have been quick to respond to the growing demand for ETFs. 75% of ETF assets are managed by three firms: BlackRock, The Vanguard Group, and State Street, who are all in a fight for market share.

ETF Fee Wars

Earlier this month, Larry Fink, BlackRock’s CEO, announced his firm, the world’s largest ETF provider, would reduce fees on some of its ETFs in the fourth quarter. A few days later, on September 21st, Charles Schwab CEO Walt Bettinger announced that his firm would slash ETF fees, now offering the lowest operating expense ratios (OERs) in the ETF industry. In a press release, Bettinger wrote:

“In this period of uncertainty in the markets, the expenses investors pay are the only sure thing. As a long-time advocate for investors, we want to offer our clients a truly low-cost way to build a diversified portfolio.”

With this move, Schwab is really competing with Vanguard, which had the lowest fees in the business before Schawb drastically cut its OERs.

Due to its unique ownership structure, Vanguard is able to keep its OERs low, while also charging zero commission on ETF trades. Vanguard is a not-for-profit company, owned by the Vanguard funds, which are owned by its clients. Not needing to make a profit for its shareholders or private owners allows Vanguard to pass on profits and cost savings to its clients

If Vanguard and BlackRock are looking to lower their fees to Schwab’s level, it won’t come cheap. According to the Financial Times:

“To match the Schwab price cuts would reduce management fees for Vanguard by between $63m to $102m. BlackRock would face a hefty bill of around $358m if it reduced charges on directly competing products, and $745m, if it reduced charges on all overlapping products to match the new prices announced by Schwab.”

Todd Rosenbluth, an ETF analyst with S&P Capital IQ, believes Schwab’s fee cuts will help it attract business, but won’t cut into the market share of BlackRock, State Street, and Vanguard. He told Financial Advisor:

“Schwab doesn’t offer sector funds or country specific funds that appeal to more tactical investors. Schwab’s ETFs appeal to investors looking for diversified equity exposure with cost being a top priority. They’re going after a broader audience. But Vanguard’s success shows that a low-cost provider can gather assets.”

Fee wars such as these are always good for consumers, but will the ETF market always be so sizzling hot? According to Bernstein Research report entitled, “Will ETF Hit a Wall?,” the answer is not exactly. Though the report predicts a very robust growth rate of 13% per year to reach $6 trillion by 2025, this number is much lower than what is predicted by many ETF providers.

However, considering that Bernstein forecasts the asset-management business as a whole will grow 6% to 7% per year, ETFs are still a good bet for the industry.


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