“This pricing strategy would be to offer their core pure passive range for free in order to retain their scale benefits and make their margin on smart beta or active products and other business lines, such as multi-asset solutions,” Jacob added. “Many investors also seek to complement their passive low-cost beta with active management using a core-satellite approach.”
Moreover, fund sponsors that opt to go with the ETF fee waiver, loss leader approach may still be able to earning revenue from securities lending. Securities lending is a practice where mutual funds and ETFs pay agents to lend out shares in their portfolios – funds are created with exposure to an underlying basket of securities – to other traders and thereby earn interest. Typically, ETFs lend securities to investors who want to short a stock.
“We show that exchange traded funds can earn significant revenue from securities lending, on order of the size of the ETF’s expense ratio,” according to a research paper, Passive Investing: The Role of Securities Lending, by Jesse Blocher and Robert E. Whaley. “We also show that ETF managers respond to the securities lending incentives by slanting their holdings toward stocks with higher lending fees.”
The research revealed that ETFs could make 23 basis points to 28 basis points per year from securities lending, and if firms are more aggressive with their lending program, securities lending could net as high as 55 basis points to 114 basis points per year.
Related: Important Trends Impacting the ETF Industry
To put this in perspective, there are currently 1,948 U.S.-listed exchange traded products with an average expense ratio of 0.58%, or 58 basis points.
As ETF sponsors enjoy increased scale and alternative avenues of turning a profit, such as steering people toward higher costing strategies and securities lending, the industry might witness fees go closer to zero. ETF investors will be the ultimate winners, tracking major benchmarks at potentially no cost.