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Passive Fund Fees Fall as Smart Beta ETF Market Grows

As strategic beta ETFs with an income or value bias have become increasingly commoditised, fees have fallen and profit margins have become squeezed

Morningstar ETF Analysts 12 September, 2016 | 12:17PM

Strategic beta, widely referred to as “smart beta,” refers broadly to a growing group of indexes and the exchange-traded products and other funds and investment products that track them.

The majority of these indexes seek to enhance returns or minimise risk relative to a traditional market-capitalisation-weighted benchmark. Others seek to address oft-cited drawbacks of standard benchmarks, such as the overweighting of the most-indebted issuers in market-cap-weighted fixed-income benchmarks.

These benchmarks and the investable products that track them exploit many of the same “factors” such as size, value, quality or momentum, or to mitigate risk in a manner similar to active managers.

This group represents a middle ground on the active/passive spectrum—deviating from a traditional, strictly passive market portfolio but doing so in a rules-based, transparent, and relatively low-cost manner.

Many have defined this space in the negative, only including in their classification those products tracking any benchmark that does not weight its constituents on the basis of their market capitalisation.

Per our definition, most of the indexes underlying investment products in this class are not market cap-weighted, but some are; for example, those that have style “tilts”—which screen their investable universe for certain characteristics and subsequently weight constituents by their market cap.

Fund Fees Fall as Popularity Rises

As the more popular factor exposures – such as those ETFs with an income or value bias – have become increasingly commoditised, fees have fallen and profit margins have become squeezed. Vanguard’s recent entry into the market, with its suite of actively managed factor ETFs, typifies this trend. Although technically classified as active ETFs rather than strategic beta, these funds offer comparable exposure to a range of the most popular factors for a fee of just 0.22%.

In an attempt to maintain profit margins and differentiate product offerings, ETP providers have developed a stream of increasingly complex multifactor funds. These products, which may boast exposure to as many as seven separate strategies or factors, currently command a premium over less exotic exposures.

The proliferation and popularity of these pricier multifactor offerings has offset the downward pressure on fees for the more-vanilla exposures. The net result is that average fees charged by strategic-beta ETPs in Europe have levelled off following a fall the previous year, with the average asset-weighted fee holding steady at 0.39% as of June 2016. As the European strategic-beta market matures, we would expect fees to drop further as assets gravitate to lower-cost funds and existing providers cut fees in response.

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  Alan Rambaldini is an ETF analyst with Morningstar.