I am starting the New Year with a focus on ETFs, a 30yr old financial product that has shown Resilience, and relentless Growth. It is simple in its use but not that simple in creating and going to market. It has even been the wrapper of choice to bridge the old world to the new digital asset world. But Distribution remains key.
In 2016, I reviewed the process of issuing an ETF and the `hidden` risks and costs. Hidden not in a deliberate sense but in the sense that investors get carried away and ignore the devil in the details.
Are ETFs Trackers that Fintech can turn into Trucks with No Brakes? Worth a review of the details since each one of us owns ETFs directly or indirectly.
Remember, 2016 was the year of The Betterment/Brexit incident that showed the ugly head of illiquidity and out of whack bid-ask spreads in ETFs.
State Street, one of the major ETF issuers, has been campaigning consistently about the myths regarding ETF costs
Understanding the true cost of an #ETF can be puzzling 🧩🤔. Learn why you should consider trading costs like bid/ask spreads when determining total cost of ownership: https://t.co/Q2xOLiO3zg#KnowTheTotalCost #SPDRLiquidity
— State Street SPDR ETFs (@StateStreetETFs) January 2, 2020
Let’s call these things with their name.
The ETF industry continues to grow and 2019 was a year of several milestones.
European ETFs AUM was hit by underperformance and closed 2018 with €633.1 bn AUM. In 2019, European ETFs reached close to $1 trillion. ETFGI, reports $960bn = €860bn.
A record $4.4 trillion of assets flowed into ETFs and ETPs in the US. ETFGI research reports this 30% growth.
The reality is that growth was mainly performance-driven.
The fact remains that it is very difficult to launch a new ETF and get it over the $100million AUM mark. This is a small-cap hell for ETFs.
2019 was the year of what I call the `Robinhood-effect`, in other words the zero-fee breakout. Several large incumbents in the US followed suit after Charles Schwab announced its zero-commission policy for trading single line stocks. This may seem as the green light to replicate indices at no cost and the democratization of rebalancing towards any kind of benchmark. But of course, nothing is what it looks like at the surface.
Indices have licensing fees that ETF issuers have to incur. Managing the tracking error of the portfolio with respect to the benchmark, simultaneously with the cash drag, comes also at a cost. Custodial charges, brokerage charges may or may not be offset by revenues from lending out securities held in the portfolio. Securities lending for ETFs that hold stocks that hedge funds may want to short (borrow) is a business that is not unusual. It is actually the way that ETFs earn some revenue and are able to offer nearly-zero cost ETFs. I am referring to the expense ratio of the ETF.
Expense ratios of ETFs (asset mgmt. fees) have been dropping too but taking into account the bid/ask spread of the ETF (which is linked to the size) is important. Also, differentiating between trading fees and asset mgt. fees.
The lowest expense ratios of ETFs are in the range of 2 or 3 bps but the catch is that their bid-ask spread may shoot up to 50bps in certain market conditions. For a complete list of low expense ratio ETFs see here.
- SPY, one the largest ETFs, has over $300billion AUM and an expense ratio of 9bps.
- Vanguard S&P 500 ETF (VOO) is another S&P500 ETF tracker with a much lower expense ratio of 3bps and $130billion AUM.
- The Invesco QQQ (QQQ) NASDAQ 100 tracker has a rather high expense ratio of 20bps and $87Billion AUM.
Yes, there are currently close to 2,000 ETFs that trade on platforms with zero trading commissions (according to a WS article). Fidelity has launched its own commission free trading of ETFs that already includes 500 such ETFs. This does not mean that these ETFs have zero expense ratios. Charles Schwab and TD Ameritrade also offer more than 500 commission-free ETFs on their platforms. Vanguard leads the pack with 1,800 commission-free ETFs on its platform.
Commission-free trading is less likely to help ETFs in increasing their assets, much like low expense ratios have not actually proven to be the key to large scale distribution of ETFs. The market has spoken on this front and the verdict is `It is all about distribution channels`.
Look at SoFi`s zero-cost S&P ETF , the SoFi 500 ETF (SFY) launched in April 2019 with zero expense ratio (at least until June 2020). The online lender has managed to accumulate $72million AUM and the average bid ask spread is 21bps (compared to zero for SPY and VOO).
Salt Financial played the same game and in an even more aggressive way last Spring. They launched an ETF with a 5bps rebate until it reached $100million AUM (a negative expense ratio). The Salt Low truBeta US Market ETF – LST has only accumulated approx. $10million AUM by now.
Their strategy was that the rebate (negative expense ratio) would be their marketing budget and when they accumulated $100million AUM, they could cover costs through securities lending. That is also the way some Vanguard Index ETFs beat their benchmark – by distributed to investors their revenues from securities lending (3 or 4bps).
CNBC reports that over the past year, there are only 4 new ETFs that have managed to accumulate more than $100million AUM. It remains bloody difficult to grow a new ETF. The only new ETFs that reached $1 billion mark are two ETFs that were heavily funded by an insurance company. The Blackrock ETF iShares ESG MSCI USA Leaders launched in May has already $1.84billion with an expense ratio 10bps and a bid-ask spread of 5ps. And the Xtrackers MSCI USA ESG Leaders Equity launched in March has already $1.7billion with an expense ratio 10bps and a bid-ask spread of 5ps and in these cases the ETFs were seeded with big money from an insurance company.
Issuers of ETFs like Schwab, BNY Mellon, Goldman Sachs, Fidelity have essentially in-house distribution channels. Schwab feeds its Schwab Intelligent Portfolios investment platform, BNY Mellon its custody client needs, Goldman Sachs has United Capital and S&P Investment Advisory to place its zero-cost ETFs, and Fidelity has its fund families. Bloomberg reports that more than 70% of U.S. ETF assets are in low expense ratio funds. In 2019, 93% of new money flowed into such low-cost products.