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Why Do Strategic Beta ETFs Charge Higher Fees?

Smart-beta ETFs are, on average, more expensive than ETFs linked to standard market-cap weighted indexes. Morningstar analysts examine why

Morningstar ETF Analysts 23 February, 2016 | 9:38AM

Strategic-beta, widely referred to as ‘smart beta’, exchange-traded products have seen explosive growth in recent years. According to Morningstar data, as of December 31 2015, there were 950 such products that seek to either improve return or alter risk relative to more-traditional market benchmarks, with collective assets of $478 billion worldwide.

In the past 18 months, we have published two Global Guides to Strategic-Beta Exchange-Traded Products, in which we defined the space and outlined some of the latest trends. In these reports, we highlighted the fact that strategic-beta ETPs charge higher fees, on average, relative to their more ordinary passive peers. Cost is an important consideration that isn’t always at the top of investors’ minds when selecting strategic-beta products.

Why the Higher Fees?

Strategic-beta ETFs are, on average, more expensive than ETFs linked to standard market-cap weighted indexes.

Strategic-beta ETFs in the US large-cap segment are the most expensive of all, in relative terms. The average TER of strategic-beta ETFs using the S&P 500 as a parent index is three times higher than that of ordinary S&P 500 ETFs. On the other hand, emerging-markets strategic-beta ETFs are only slightly more expensive than their cap-weighted counterparts, while strategic beta ETFs offering exposure to Japanese equities are cheaper than their plain-vanilla peers, on average.

There are several factors that can explain the relatively higher fees taken by strategic-beta ETFs. For starters, these funds often bear the cost of higher index licensing fees. ETF providers merely pass on the higher fees that index providers charge them for the extra costs they incur in the process of researching, manufacturing, and marketing these strategies.

Some ETF providers, like WisdomTree, Ossiam, and First Trust, which specialise in strategic beta funds, develop their own indexes. Hence, their funds don’t incur any third-party index licensing fees. But that doesn’t translate into lower TERs—quite the contrary: Funds offered by self-indexers are amongst the most expensive. The creation and marketing of new–especially non-plain-vanilla–indexes require resources, and providers need to reach sufficient scale to make it cost-effective.

The higher fees taken by strategic-beta ETFs can also be simply explained by the fact that these funds offer ‘new’ and ‘innovative’ strategies. ETF providers leverage this ‘newness’ and ‘innovation’ to justify premium pricing, no different from any other product in any other industry at the early stage of its life cycle. Finally, charging a premium for strategic-beta offerings can be a way for many ETF providers to regain some of the profit they have lost as a result of the fee cuts within their core offerings in an attempt to attract assets.

Costs are Improving

Strategic-beta ETFs are considerably cheaper to own than traditional actively managed funds. Average fees in the European strategic-beta ETF space have declined in recent years. The average TER has dropped to 0.39% from 0.43% five years ago. We expect fees will continue their downward trend as the market matures and competition intensifies. But the ever-growing complexity of the underlying strategies will continue to be leveraged by index and ETF providers as a justification for premium prices relative to more-vanilla fare—whether warranted or not.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure