The Darker Side of the ETF Fee War

November 30th at 10:45am by Tom Lydon

It’s no secret that there is an exchange traded fund price war raging on, with top providers aiming to offer the best product at the lowest price. Conventional wisdom tells us that this can be beneficial to investors, but are there other implications that could surface?

“So, what are the effects of these price wars?  They do reduce costs for some investors but there are land mines as well. In order for the ETF providers to cut fees they have to cut operational costs as well to run the funds more efficiently.  Most ETFs by their nature are run efficiently so the cost cutting can hit in other areas,” Richard Keary wrote for Wealth Management.

Heavyweight providers are leading the charge in the recent war, with Vanguard, formerly the low price leader, finding close competition from Charles Schwab and BleackRock’s iShares. Fee reduction is just one aspect of attracting market share, but it can be the most important in that it can gain the initial attention of an investor. Low fees also maintain the market share, which is just as important as attracting it. [PowerShares Slashes Fees on Six ETFs]

However, when it comes to low expense ratios, there are a lot of factors at play other than cutting fees and pricing it right. Index tracking error is important because it can control the liquidity of an ETF. ETF liquidity is an important feature because an ill-liquid fund will not attract investors nor assets. Trading costs and brokerage fees are also part of the total cost package and must be considered. If an investor is trading frequently, trading costs can add up quickly, and cut into principle. Then a lowered expense ratio is offset by the high costs of moving in and out of the fund.

Another important factor that investors should consider over fee reduction is the asset allocation within the underlying index. This is where is can get tricky because investors must do their homework and research the funds to figure out exactly what stocks the ETF holds, how much of it, and how representative the index actually is compared to the title of the fund. A failure to perform correctly can offset any reduction in fees and voids the notion that lower fees are most important. [Vanguard Shift Puts Focus on ETF Benchmarks]

“Index construction is a key element when looking at an ETF. What are the underlying securities, how do they fit into my client’s asset allocation model and what are the trading costs and liquidity associated with the securities. There is a huge difference between creating a benchmark index and a tradable, investable index,” Keary wrote. [ETFs Target Indices to Lower Fees Even More]

So, quality of the ETF overrides low cost if the ETF is going to suffer underperformance due to lower prices. The performance of the index and the quality of the companies it holds can make a bigger impact upon a portfolio than lower fees. [iShares S&P 500 ETF Attracts Cash After Fee Cut]

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

Tickers