By Henry Ma, Julex Capital
One of the recent developments in the ETF strategist industry that caught advisors’ attention is so-called free ETF portfolios.
Fierce Competition and More Fee Conscious Investors
Facing fierce competition and more fee conscious investors, many ETF issuers created ETF portfolio strategies with their own proprietary ETFs and offered them for free. On the surface, it sounds like a good thing for investors because they help lower the investment expenses. However, if you look more closely under the cover, it is not clear-cut whether there is a cost-saving for using free ETF portfolios.
Table 1 compares the fees of three different ETF Portfolios. Portfolio A is a typical portfolio created by ETF strategists. Normally ETF strategists use the most liquid and least expensive passive ETFs to create ETF portfolios, most of which are dynamic and tactical in nature. Depending on how active the portfolios are managed, the fees of ETF portfolios vary. In this example, we assume that the ETF strategist charges 30 bps for a total portfolio solution, then the total fee including the expenses of the underlying ETFs (assuming 15 bps) is 45 bps.
Portfolio B is an example free ETF portfolio created by ETF issuers. Depending on the breadth of the ETFs they issue, ETF issuers normally use a combination of the passive ETFs and their proprietary active ETFs. Just like active mutual funds, active ETFs have high expense ratios. In Portfolio B, we assume that the active proprietary ETF charges 100 bps, then the total fee is 58 bps, which is much higher than that of Portfolio A even there is no extra strategist fee.
Portfolio C is another type of free ETF portfolio. The largest ETF issuers often offer ETF portfolio strategies with their own passive ETFs at no extra charge. In this example, the total fee of the portfolio is 15 bps, the lowest among three portfolios. However, this type of portfolio typically follows a passive strategic asset allocation approach without any active management. Advisors can implement a core/satellite approach to manage client accounts by using this portfolio as a core holding and other active/tactical ETF portfolios as satellites to enhance returns or/and reduce risk.
Additionally, the proprietary ETFs used in the free Portfolio B and C may not be the best in their asset class or investment style categories. In many cases, there are substitutes managed by other firms that may have better performance record, lower expense ratios or more liquidity.
Table 1: Total Fee Comparison of Three Hypothetical ETF Portfolios*
| Portfolio A | Portfolio B | Portfolio C | ||||||
| Weight | Fees (Basis Points) | Weight | Fees (Basis Points) | Weight | Fees (Basis Points) | |||
| Passive ETFs | 100% | 15 | 50% | 15 | 100% | 15 | ||
| Active/proprietary ETFs | 0% | 100 | 50% | 100 | 0% | 0 | ||
| Strategist Fee | 30 | 0 | 0 | |||||
| Total | 45 | 58 | 15 | |||||
*Note: The fees in the table are for illustration purpose only and do not represent the actual fees managers charge.
Management fees of ETF strategies have always been a confusing issue for many advisors. I will try to provide a framework here. Morningstar tracked 1,180 strategies from 182 firms with total assets of $123 billion through December 2017. The ETF strategies varied in investment universe, asset breadth, portfolio implementation or ETF exposure type.
Although it is challenging to have a unified pricing framework, the basic business principle should apply here. Management fees should be proportional to the value the manager offers or intend to offer. In that sense, tactical ETF strategies will charge the highest fee because they intend to outperform the strategic portfolios and/or help reduce total portfolio risk. Strategic ETF portfolios should charge the lowest fee because they don’t intend to generate any excess returns or reduce portfolio risk. The hybrid strategies which are combinations of the strategic and tactical components should charge something in between. Table 2 illustrates a unified framework of how the ETF strategies should be priced using an example.
Table 2: A Pricing Framework of ETF Portfolios*
| Strategic ETF Portfolios | Hybrid ETF Portfolios | Tactical ETF Portfolios | ||||
| Weight | Fees (Basis Points) | Weight | Fees (Basis Points) | Weight | Fees (Basis Points) | |
| Strategic Component | 100% | 10 | 50% | 10 | 0% | 10 |
| Tactical Component | 0% | 100 | 50% | 100 | 100% | 100 |
| Total | 10 | 55 | 100 | |||
*Note: The fees in above table are for illustration purpose only and do not represent the actual fees managers charge.
Free ETF Portfolio Strategies Really Worth it?
In summary, when they evaluate the expenses of ETF portfolio strategies, advisors should consider the total fee including both the ETF strategist fee and the fees of the underlying ETFs. Some of the free ETF portfolios, especially those with active proprietary ETFs, may be more expensive. Secondly, advisors should pay ETF strategists according to how much potential extra value the strategies may add to clients’ portfolios. For a strategic passive ETF portfolio, advisors can easily create it by themselves and should not pay much. For a tactical ETF portfolio, advisors should pay more because there is a potential benefit of enhancing returns and/or reducing risks.
Disclosure: This article is for the purpose of information exchange only. It is not a solicitation or offer to buy or sell any security. You must do your own due diligence and consult a professional investment advisor before making any investment decisions. All information posted is believed to come from reliable sources. We do not warrant the accuracy or completeness of information made available and therefore will not be liable for any losses incurred.