Pathfinder: Keeping ETF fees real

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Exchange Traded Funds (ETFs) are recognised globally as a highly efficient way of accessing equity markets.   They provide instant and diversified exposure to broad global equities or to a particular country, sector or region.  And US listed ETFs are cheap, very cheap - with management fees of 0.10% or even less.  In this commentary John Berry looks at ETF management fees from a New Zealand perspective.

Monday, September 9th 2013, 10:30AM

by Pathfinder Asset Management

What are the cheapest ETFs?

The US really does have a range of breathtakingly cheap ETFs.  Here are 5 ETFs from different providers -

Provider	Ticker	ETF equities	ETF fee	ETF Size
State Street	SPY	S&P 500	0.09%	US$147 billion
iShares	IVV	S&P 500	0.10%	US$44 billion
Vanguard	VOO	S&P 500	0.05%	US$11 billion
Charles Schwab	SCHB	Broad US market	0.04%	US$2.2 billion
Charles Schwab	SCHD	US Dividend Equity	0.07%	US$1.2 billion

All of the above ETFs have a management fee of 0.10% or lower.  That is exceptional value – however it is worth noting some common features.  Firstly virtually all the cheapest equity ETFs  cover the US market – only 1 of the 23 US listed equity ETFs with a management fee of 0.10% or lower covers stocks outside the US (SCHF).   Secondly, they are large, very large in terms of FUM – this may give us some insight into why they are so cheap.

How can ETFs be so cheap?

In the US there are 1,499 listed ETFs with a total market capitalisation of US$1.5 trillion.  The NZ market has 5 listed ETFs with a capitalisation of NZ$315m.  The total US ETF market has 300 times more listings and 6,000 times more value invested in US$ terms.   (Yes, incredibly,  US ETFs really have six thousand times more invested!)

It is not only the total market size that is different – the size of individual ETFs also differs significantly.   NZ ETFs have an average size of US$54 million compared to just over US$1 billion for the average US listed ETF.   This size differential means that a US fund with a much lower management fee receives a significantly higher management fee on a dollar basis.  Let’s compare the 5 cheap US listed ETFs from the table above with the Smartshares ETFs covering NZX stocks:

Provider	Ticker	ETF equities	ETF fee	ETF Size	ETF Fee (pa)
State Street	SPY	S&P 500	0.09%	US $147 bill	US$132m
iShares	IVV	S&P 500	0.10%	US $44 bill	US$44m
Vanguard	VOO	S&P 500	0.05%	US $11 bill	US$5.5 m
Charles Schwab	SCHB	Broad US market	0.04%	US $2.2 bill	US$880,000
Charles Schwab	SCHD	US Dividend Equity	0.07%	US $1.2 bill	US$805,700
Smart Shares	TENZ	NZX Top 10	0.60%	US $42 mill	US$253,000
Smart Shares	MIDZ	NZX Mid Cap	0.75%	US $34 mill	US$251,000
Smart Shares	FONZ	NZX 50	0.75%	US $85 mill	US$637,000

We see how the massive US listed ETFs can get such incredibly low fees – they have scale.  Size means the US market leaders can force pricing down and still generate significant revenue.  This puts fee pressure on the rest of the US ETF market – or requires other providers to offer more niche product.  (Note: while the average US ETF is just over US$1 billion this is skewed by some “mega-large” ETFs – the median ETF size is around US$70 million).

What are the costs of US ETFs that compare to NZ?

The “mega-large” ETFs covering vanilla US equity sectors can be run very cheaply and efficiently.  But not all US listed ETFs are cheap -  the majority have management fees closer to NZ ETFs.  This is particularly true of country ETFs (outside the US) and niche equity sectors.

The table below shows a range of country ETFs listed in the US – plenty of investors would be screaming “expensive” if these same ETFs were listed in NZ.  But these come from a wide range of providers and are fair comparisons for our NZX listed SmartShares ETFs:

Region	Country	Provider and Ticker	ETF Fee	ETF Siz (US$)
North America	US small caps	iShares (IWC)	0.71%	US$761 million
North America	Canada	iShares (EWC)	0.51%	US$3.4 billion
South America	Brazil small caps	Market Vectors (EWZ)	0.60%	US$225 million
South America	Chile	iShares (ECH)	0.59%	US$378 million
Asia	China	State Street (GXC)	0.59%	US$859 million
Asia	India	Powershares (PIN)	0.78%	US$293 million
Asia	India	Wisdom Tree (EPI)	0.83%	US$682 million
Asia	Vietnam	Market Vectors (VNM)	0.76%	US$356 million
Emerging Markets	Small Caps	State Street (EWX)	0.65%	US$760 million
Europe	Germany	iShares (EWG)	0.51%	US$4.8 billion
Europe	Spain	iShares (EWP)	0.52%	US$384 million

Note that perhaps the best comparison of all for SmartShares ETFs is the US listed ENZL ETF which covers the NZ market.  This US$147m fund comprises 25 NZ stocks and has a management fee of 0.51%.  That single ETF is about the same size as the combined size of SmartShares’ 3 ETFs covering NZ – and yet it does not carry a significantly lower management fee.

Not all US ETFs are cheap…..

If we limit the universe of US ETFs to just equity ETFs and exclude leveraged and inverse ETFs then we have a total of 774 ETFs.   Here is a breakdown of management fees for those 774 US listed ETFs:

ETF fee bands	ETFs in each band	ETFs in bands (% of total)	Cumulative ETF count (%)
Less than 0.05%	2	0.26%	0.26%
0.05 to 0.25%	105	13.57%	13.83%
0.25% to 0.45%	161	20.80%	34.63%
0.45% to 0.55%	166	21.45%	56.08%
0.55% to 0.75%	238	30.75%	86.83%
0.75% and above	102	13.17%	100.00%
TOTAL	774	100.00%	100.00%

So while we all expect very low ETF fees, in fact two thirds of US listed equity ETFs have a management fee above 0.45%.  That is surprising.  Close to half have management fees exceeding 0.55% (meaning there are plenty of US ETFs with the same or higher fee structures as NZ listed ETFs!)

Why NZ ETF fees will never be 0.25% (and why you shouldn’t expect them to)

New Zealand funds are structurally different to US funds.  For starters in NZ the Unit Trusts Act requires an independent trustee.  In addition most fund managers outsource the fund accounting because without scale of NZ$1 billion+ it is generally uneconomic (on a cost basis) for fund managers to do the unit pricing in-house.  Using an external accounting provider also adds a serious layer of protection for investors (David Ross could not have started - let alone carried on for years –if he had independent  accounting, an independent custodian and a third party trustee).  But each of these components of a New Zealand ETF (and managed fund) costs. 

Let’s have a look at the base costs in NZ for building an ETF:

Provider	Typical Cost (% of fund size pa)	Number of providers in New Zealand
Trustee	0.08%	5
Fund accounting	0.13%	3
TOTAL COST	0.21%

Two things are clear from the table above.  Firstly, if an ETF provider is pricing its product to cover its costs, you will never see an ETF management fee of 0.25% or less in NZ.  That fee only covers accounting and trustee fees – before even thinking about covering fund audit, manager office costs and staff salaries, tax and legal fees. 

The second point is that the small size of the NZ market means there are only a handful of service providers for the funds management industry.  We need a much larger market supporting more and larger providers if we want to drive costs down.  

Concluding thoughts

So what are the conclusions regarding ETF management fees?  Some thoughts to ponder:

1. The US has some incredibly low ETF fees: The size and scale of the US market means that it can support ETFs with very low management fees in the region of 0.10% and lower. Although note that only 23 out of 774 US listed equity ETFs actually have fees at such low levels.
2. NZ will never have these low fees:  In NZ we will never see ETF management fees at 0.10%.  This is in part because we do not have scale in the market – the US has 300 times more listed ETFs than NZ and 6,000 times more value invested.  This is also in part because of the underlying variable cost component of funds in NZ.  In fact don’t expect to see listed ETFs in NZ with a management fee below (or even near) 0.25% - that just won’t happen. 
3. Surprisingly, most US ETFs are not incredibly cheap:  The very low cost ETFs in the US get the headlines but they do not fairly represent US ETFs.  Two thirds of US listed equity ETFs have management fees above 0.45%, nearly half have fees above 0.55%.
4. Contrary to popular belief NZ ETFs may not be outrageously expensive:  When looking at NZ management fees it is important to compare like for like – the very low US ETFs with 0.10% fees are not the right comparison.  What you should expect is for NZ listed ETFs to be competitive with the equivalent country ETFs listed in the US.  These generally have management fees in a range of 0.50% to 0.80%.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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