The importance of investment costs can never be overemphasized. They can greatly erode returns over the long-term. And, worst of all, we have little option but to pay them irrespective of our chosen investment’s performance. In fact, paying costs is the only ex-ante certainty when investing. As such, an easy way for investors to maximise what by definition are uncertain returns is to pro-actively seek investment vehicles carrying the lowest possible costs.
Over the past few years, as return expectations for most asset classes have been lowered, the issue of costs has gained prominence. This partly explains the growing popularity of passive investment vehicles that are luring investors with the basic premise of easy access to all sorts of market exposures at a fraction of the cost of actively-managed funds.
The theory goes that the actively-managed fund industry will have little option but to also trim costs in order to remain competitive. However, for now, many observers remain sceptical about the chances of a comprehensive lowering of fees in the mutual fund industry; routinely citing the lack of hard evidence of active funds responding to cost pressures from the likes of exchange-traded funds (ETFs).
Meanwhile, we can clearly see that the first battles of what could develop into a full-scale fee war have taken place among the ETF providers.
A study conducted by Morningstar comparing the costs of investing in ETFs and traditional trackers has revealed that, on average, total expense ratios – or their new incarnation, the ongoing charge – for European-domiciled equity ETFs have steadily dropped since 2008. This decline has come primarily as a result of new products undercutting older ones, rather than the latter cutting fees.
Investor’s take-up of these new, cheaper ETFs has been proceeding at a somewhat slow pace. However, their mere existence has created a more competitive environment for investors; one where the odds are gradually building for the long-established providers to also cut their fees in order to protect their market share.
The arrival of very competitively priced ETFs has also prompted reaction from providers of traditional index trackers. Mirroring the trend observed for traded funds, overall expense ratios for equity index funds have also decreased on average over the past five years. This trend has been particularly prominent in the UK since the arrival of ultra-low cost providers like Vanguard. The days when traditional index funds could get away with charging unjustifiably high fees to captive retail investors may be gone.
In fact, with regulatory changes like the Retail Distribution Review (RDR) expected to generate new waves of interest in passive instruments, more providers of traditional index funds may be forced to follow in the steps of Legal and General, which cut fees on a number of its core index funds back in April to make them attractively competitive against both the ETF contingent and other traditional index trackers.
Going forward, we expect the growing popularity of passive instruments, helped by regulatory changes like the UK’s RDR in other European countries, to trigger a fee war similar to the one witnessed in the US. We expect fund providers to share economies of scale with investors, resulting in lower fees. This is standard practice in the US, where firms explicitly state by how much the expense ratio will be reduced as assets grow past different levels, but it is virtually unheard of in Europe. We also anticipate more proactive, competitively-driven fee reductions from fund providers seeking to grab the attention of investors.
Finally, we see cost pressures spreading to other areas of the value chain, with ETF and index fund issuers continuing to pursue ways to reduce index licensing fees—such as changing index providers or self-indexing—and we would also hope providers would share those savings with investors. Ultimately, we would expect that this cost competition in the passive space will also increase fee pressure in the realm of actively managed mutual funds—a positive externality to the benefit all fund investors.
See the full Morningstar research paper on ETF and tracker funds here.
A version of this article was first published in Investment Adviser.
