ETF Price War #2.0

Focus shifting to trading and transactions costs

Costs are still falling in the passive space. “Ten years ago, the lowest cost investment was probably a traditional mutual fund at around 0.30% for a mainstream market – and not an ETF.  Now, the lowest cost products in Europe charge a Total Expense Ratio (TER) from 0.04% or four basis points for US or UK equity index trackers. And cost reductions are starting to be seen in emerging markets” says Lyxor ETF’s Head of ETF Strategy for Northern Europe, Adam Laird. TERs includes auditor, administrator, custodian, and exchange fees, among others.

In fixed income, yields still at record lows in Europe clearly increase pressure on fees, which eat up yields. In US or UK Government bonds, Lyxor now offers ETFs with a TER of 7 basis points.

Some exceptions to the general rule of lower cost ETFs include more sophisticated and complex products: such as leveraged, inverse or short, and emerging markets. “Leveraged and inverse ETFs, which we offer for some Southern European markets, do carry a premium, as there are higher costs. Emerging markets tend to have higher costs as well, as the cost of investing in EM is higher, due to admin costs, and restrictions in licensing” explains Laird.

He admits that ETFs directly investing into commodities have not seen much cost reductions, but points out that, “ETFs can be used to access commodity proxies, such as mining shares, and infrastructure equities, at much lower cost than private equity for instance”.

Sub-scale ETFs

Smaller ETFs can also cost more. Costs on ETFs have come down mainly because fees have been cut, but also as a function of industry growth, which allows non-fee costs to be spread over a larger pool of assets. Conversely, smaller products are handicapped by a fixed cost drag. “Some smaller products are not sustainable. We need to make sure funds are of a sufficient size and scale to maintain low costs”, says Laird.

If an ETF cannot gather a critical mass of assets, there are two courses of action. “We have made changes to the product range. We have shut down products that did not take off, but more often restructured them by changing into a fund or strategy that has more appeal to make sure it is sustainable” he adds. For example, in 2012 Lyxor closed a number of very small ETFs, and in 2017 Lyxor closed USD share classes for a number of ETFs, merging them into Euro share classes.

Stock lending and zero cost ETFs

Whether ETFs are structured as physical or synthetic does not make much difference to fees. “Lyxor’s core range are fully physical, with no stock lending, because in mainstream markets that is what investors want to buy” says Laird.

“In other, more niche equity products, we take a pragmatic approach to stock lending and may do it if it earns a worthwhile premium. Net revenue goes back to the fund” he adds.

Zero cost ETFs have hit the headlines with a US provider most recently launching one that makes use of security lending revenues to defray costs. Argues Laird, “in Europe, stock lending revenues have to go back to the fund. In Europe, and especially the Nordics, there is much more mistrust of people who are doing clever accounting to produce a zero-cost fund. Investors want full clarity on what is happening at what point”.

Trading and transactions costs

Ongoing charges on ETFs have now fallen so far, that trading costs can now be far greater than annual running costs. The costs involved in buying and selling an ETF – commissions, bid/offer spreads, and any market impact – could in some cases add up to a multiple of the TER.

The highest reported bid/offer spreads, of 1% or more, have applied to single country, emerging markets equity ETFs. Yet bid/offer spreads on some ETFs are as low as one basis point and can in some cases be lower than the bid/offer spreads on the underlying assets, in areas such as high yield debt. They can also fluctuate, and may increase during more volatile market conditions.

Moreover, trading costs could vary between brokers, market makers and venues, which include exchanges and off-exchange venues. Since January 2018, MiFID II now requires post-trade reporting for ETF trades, which can help investors to benchmark the quality of their execution for best execution obligations. Prior to MiFID II, bilateral, off-exchange, Over The Counter (OTC) trades were not reported.

“Lyxor has a dedicated capital markets team, which has the sole aim of helping people to find the best way to execute the trades” says Laird.

Stamp duty is also relevant in some markets. While no stamp duty applies to buying ETFs, the ETFs themselves do need to pay it when they trade physical shares in some markets. For instance, a UK equity tracker fund pays 0.50% to buy physical shares, but nothing for futures. Average holding periods determine over what period this cost can be spread. If investors use a physical ETF as a short- term trading vehicle, the cost could be significant in markets where stamp duty applies. However, Lyxor’s research suggest that, “most investors use ETFs as a buy and hold investment. We saw net inflows over the market declines in late 2018. There has not be a significant net outflow in the ETF market” says Laird.

Outlook

Laird sees the asset management industry moving towards a barbell structure, with low cost passives including ETFs at one end of the spectrum, and genuinely active managers at the other. In between, there is no room for a halfway house of so called “closet trackers” charging high fees for low added value and low active share products.

What about active ETFs? So far, Laird observes “Active ETFs tend to be active-lite – lower cost but also lower active share, more like an enhanced index tracker”. These can be palatable to investors, because the fees are commensurate with the limited degree of active management.