By Elisabeth Kashner, CFA | July 22, 2019
The first half of 2019 marked a tiny shift in fund investment trends, with investors showing some willingness to try complex strategies.
For years, dollars have flowed to the cheapest, broadest, and simplest household-name passive funds such as IVV-US, the iShares Core S&P 500 ETF. The trend rewarded low-cost providers who operate at enormous scale—mainly BlackRock’s iShares Core suite and Vanguard—and has threatened traditional active managers. As investors streamlined their portfolios, fees trended towards zero, prompting many to ask if asset management would remain a viable business.
2019 seems to be going the same way so far, but with a twist. Active management is still losing assets to passives and fees continue to trend downward, but investors’ preferences have become less monolithic. Flows year-to-date have favored factors, ESG, and cash management funds. These complex funds charge marginally higher fees compared to their simple vanilla counterparts.
Pricing power has come under pressure as the fee wars have followed the flows. Asset managers who had pinned their hopes on upselling complexity are now caught in the fee wars they had hoped to avoid.
Investors are Willing to Pay More for Complexity, For Now
Between 2016 and 2018, fund inflows favored broad-based, cap-weighted equity ETFs with exposure to the S&P 500, developed markets, and emerging markets. But in the first half of 2019, the list of the top five ETFs by flows changed. A low volatility fund displaced one of the S&P 500 funds and an intermediate-term bond fund replaced one of the developed market equity funds.
Top Five ETFs in 1H 2019 (by flows)
|TICKER||NAME||STRATEGY||ANNUAL COST 6-30-19|
|VOO||Vanguard S&P 500 ETF||Vanilla||0.03%|
|IEFA||iShares Core MSCI EAFE ETF||Vanilla||0.07%|
|USMV||iShares Edge MSCI Min Vol USA ETF||Low Volatility||0.15%|
|IEF||iShares 7-10 Year Treasury Bond ETF||Vanilla||0.15%|
|IEMG||iShares Core MSCI Emerging Markets ETF||Vanilla||0.14%|
Renewed interest in bond funds is not surprising given the dramatic interest rate decrease we saw in the first six months of 2019. The breakthrough for USMV is an event. As shown in the flows chart below, after years of stability, USMV’s asset level turned upward starting in Q4 2018 and accelerated in 2019.
USMV’s fees, while low in the absolute sense, are five times higher than its major vanilla competitors and more than seven times higher than the cheapest fund in the U.S. total market segment.
For many ETF asset managers this fee gap is a key part of the business model. They hope to attract clients to a brand by offering cheap, plain vanilla funds and then upsell more complex, pricier products. For example, BlackRock offers both Core and Edge product suites. Core funds offer plain vanilla exposure while Edge funds use factor-based strategies. BlackRock prices Edge products two to five times higher than Core. The table below shows the current price difference between Edge and Core funds in the same market segment.
Cost Comparison Between BlackRock iShares Core and Edge Funds
|MARKET SEGMENT||CORE AVERAGE COST||EDGE AVERAGE COST|
|Equity: U.S. – Total Market||0.05%||0.16%|
|Equity: U.S. – Mid Cap||0.07%||0.25%|
|Equity: U.S. – Small Cap||0.07%||0.25%|
|Equity: Developed Markets Ex-U.S. Total Market||0.06%||0.28%|
|Equity: Developed Europe Total Market||0.09%||0.25%|
|Equity: Emerging Markets Total Market||0.14%||0.35%|
|Fixed Income: U.S. – Broad Market, Broad-based||0.06%||0.25%|
On the surface, 2019 year-to-date flows suggest that the upselling strategy is working. However, a deeper dive reveals that investors are demanding ever-cheaper products across the board, sending flows to the cheapest funds within a strategy. The fee wars may soon level the playing field across strategies and complexity levels.
Factor Fund Fees March Toward Zero
We see the trend toward lower fees in flows activity within factor strategies, ESG, and even actively-managed bond ETFs. So far in 2019, investors pulled $447 million from iShares S&P 500 Growth (IVW-US) and $1.39 billion from iShares S&P 500 Value ETF (IVE-US)—each of which costs 0.18%—while investing $1.58 billion in SPDR Portfolio S&P 500 Growth ETF (SPYG-US) and $1.97 billion in Vanguard Value ETF (VTV-US), which both cost just 0.04%.
The same preference for cheapness showed up in low volatility funds. In this case, both USMV and its competitor Invesco S&P 500 Low Volatility ETF (SPLV-US) attracted flows but the lion’s share went to the cheaper product. USMV, with fees of 0.15%, brought in $5.9 billion while SPLV, with a 0.25% price tag, netted just $2.0 billion. Granted, investors may also prefer USMV’s wider market cap spectrum and its focus on minimizing portfolio volatility in comparison to SPLV’s large-cap, single-stock volatility approach but it’s hard to ignore the 0.10% price differential.
Multi-factor funds don’t have as dramatic an example as growth, value, and low volatility but still show a migration to low-cost funds. 35 of the 160 U.S. large cap ETFs take a multi-factor approach to portfolio construction. On average, the 35 funds that gained market share in the first half of 2019 cost 0.15% per year less than those that lost market share.
ESG Interest is Up, Fees are Down
Recent ESG ETF launches offer an even more dramatic example of fee compression in action. $2.5 billion of the $3.9 billion that flowed to ESG-oriented ETFs in the first half of 2019 went to two newly launched bespoke funds, one from BlackRock and one from DWS, both priced at 0.10% per year. The launches undercut Vanguard ESG U.S. Stock ETF, which now looks expensive at 0.12%.
One of the new ESG funds, Deutsche Bank’s Xtrackers MSCI USA ESG Leaders Equity ETF (USSG-US), could have captured assets from Goldman Sachs JUST U.S. Large Cap Equity ETF (JUST-US), which costs 0.20% per year. JUST-US lost $102 million on March 8, 2019; that same day, USSG-US saw its first inflow of $843 million.
The $102 million that flowed out of JUST may have belonged to Ilmarinen, the Finnish pension fund that worked with DWS to launch USSG. Thanks to the Finns, U.S. investors now have little reason to pay more than 0.10% for a broad-based U.S. ESG ETF.
The Fee War is Everywhere
Strategy-within-a-segment cost analysis reveals the same pressures we see in value, growth, low volatility, and ESG funds at work across a multitude of equity ETF investment strategy types. The table below shows the aggregate annual cost gap between ETF market share gainers and losers within a segment and strategy for competitive strategies with combined AUM of $1 billion or greater.
Annual Cost Gap Between ETF Gainers and Losers by Strategy
|Currency Hedged Vanilla||0.38%||0.38%|
Fixed Income ETFs Jump into the Fray
The price war is also heating up among fixed income ETFs at both ends of the complexity spectrum. Vanilla funds are duking it out over a handful of basis points while J.P. Morgan has made dramatic moves in actively-managed cash management ETF pricing. Like the equity table above, the table below shows the average cost difference by market segment for U.S. fixed income ETFs that gained and lost market share during the first half of 2019.
Annual Cost Gap Between Fixed Income ETF Gainers and Losers by Market Segment
U.S. FIXED INCOME MARKET SEGMENT
|Broad Market Investment Grade||0.04%||0.05%||0.07%||0.37%|
|Broad Market Investment Grade Floating Rate||0.15%||0.20%|
|Corporate Investment Grade||0.16%||0.15%||0.31%||0.26%|
|Corporate Investment Grade Short-Term||0.07%||0.08%|
|Corporate High Yield||0.17%||0.46%||0.40%||1.25%|
|Government, Inflation-linked Investment Grade||0.07%||0.19%|
|Government, Municipal Investment Grade||0.15%||0.10%|
|Government, Mortgage-backed Investment Grade||0.07%||0.07%|
J.P. Morgan’s most successful bond fund—JPMorgan Ultra-Short Income ETF (JPST-US)—is rapidly overtaking long-time incumbent PIMCO Enhanced Short Maturity Active ETF (MINT-US). JPST costs just 0.18% or half of MINT’s 0.35%. From inception through June 30, 2019, JPST outperformed MINT by 0.22% per year with all but 0.04% of the difference explained by cost.
From JPST’s launch through the end of 2018, MINT and JPST split most of the flows into cash-like ETFs. JPST gained market share at MINT’s expense but both funds grew. This year, JPST captured $2.27 billion of inflows while MINT suffered $275 million of outflows. MINT’s AUM flatlined while JPST’s climbed.
JPST is hardly an outlier. 2019’s fee wars have reached every asset class and strategy. While some strategy/segment combinations still command a price premium, the direction is clear.
Every basis point of cost savings is a benefit for consumers but threatens asset managers’ revenues. Today’s loss-leader strategy cannot generate a profit if margins collapse to zero across product types. What will the business model look like if/when investor preference pushes fees for funds like USMV and JPST down to 0.10% or 0.05%?