ETF race to zero fees could zoom into negative territory

An expert from a noted university argues that fees might not be an issue for ETF investors much longer

ETF race to zero fees could zoom into negative territory
While they still make up a small piece of the investment-fund universe, ETFs have been growing at a breakneck pace, thanks in no small part to their remarkably low fees. And one expert thinks they can boldly go where no fund has gone before.

“[T]he [zero-fee] barrier could be broken in the next year or two,” said Dr. Derek Horstmeyer, an assistant professor of finance at George Mason University, said in an article on the Wall Street Journal. “Even a negative-fee ETF—where the fund pays investors to invest—might be possible.”

Horstmeyer noted that numerous brokerage houses are now able to offer annual fees of just 0.03% on US market-index ETFs. That has come not just because of the US ETF industry’s meteoric rise to reach US$3 trillion in AUM, but also due to a steady decline in operating expenses.

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Citing data from Morningstar and the Investment Company Institute, he said past trends suggest each US$290 billion increase in inflows into index ETFs and mutual funds drives a 0.10% decline in the average expense ratio of an index fund. That math works out to index ETFs possibly reaching the zero-fee barrier off a minimum of US$870 billion more flows into the index-fund arena.

According to Horstmeyer, the US ETF industry has seen average quarterly inflows exceeding US$100 billion for the past two years. “If current inflow trends continue, [the launch of zero-fee index ETFs] could hypothetically happen within the year,” he said.

He said measuring the expense ratios of three ultra-low-cost ETFs — funds from Schwab, iShares, and Vanguard — against industry assets paints a slightly more conservative picture. “If the current assets/expense ratio relationship holds up, one of these ETFs could hit the zero barrier if there is $1.5 trillion more in industry ETF assets (aggregate), or approximately 2½ years at current inflow rates.”

Another path ETFs could take to further reduce their fees is generating revenue through share lending. Some short sellers may approach ETF providers to borrow shares of stocks that they bet will fall in price. The providers, Horstmeyer said, could lend some of their holdings (or shares of their own ETFs) to short sellers; in return they could charge lending fees and make money on collateral that borrowers would have to post.

“Some funds do more of this than others,” Horstmeyer said. He cited one Schwab fund that held collateral amounting to US$36.5 million in 2017, equating to just under 0.3% of its portfolio on loan. Many other ETF providers, he claimed, have been more aggressive, achieving loan rates of 1.5% to 2% of total assets since 2010.

“If Schwab decided to lend upward of 2% to 3% of its holdings … this could get it well on its way to the $3.42 million in shorting revenue needed to have a sustainable zero-fee ETF,” he said.

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