ETF Fees Creep Higher

The net expense ratios of exchange-traded products (ETPs) continue to creep higher. The average net expense ratio (ER) grew from 0.61% to 0.62% during the 12-month period ending in June 2013 according to data provided by Morningstar. The increase is a result of new product development that has focused on more complex strategies and alternatives to stocks and bonds.

ETPs include exchange-traded funds (ETFs), exchange-traded notes (ETNs), grantor trusts, partnerships and other products that have an intraday share or creation and redemption mechanism.   ETFs dominate the industry. They account for roughly 80% of all products and 90% percent of all assets.

Figure 1 illustrates the gradual ascent in the average net expense ratio (ER) of all ETPs. It represents about 1,470 funds through June 2013. A sharp increase occurred between 2005 and 2006. The increase has slowed to a more gradual pace since this period.

Figure 1: The Cumulative Average Net Expense Ratio of ETPs

The Cumulative Average Net Expense Ration of Exchange Traded Products

Source: Morningstar Principia through June 2013

Driving the fee increase is the cost of newly issued funds. Since 2010, the average net ER of a newly issued fund is 0.70%, according to Morningstar data.

Higher fee funds may be proliferating in number, but that doesn’t mean their assets are. ETFs are advertised as low-cost, and investors are listening. A majority of new assets that flow into ETFs have low fees and track broad market averages. Vanguard research found that 74% of new assets flowed into the lowest expense quartile funds between 2003 and 2012, and ETFs with the “lowest of-the-low” expenses took in about half the assets for the lowest quartile.

Some firms have a better record of keeping fees low and attracting assets than others. Of the five largest providers, Vanguard ETFs has the lowest expense ratios by a wide margin. Figure 2 illustrates the average net expense ratios of these five large ETF providers by assets under management. The number of funds each company owns is depicted next to the name. The “All Other” category represents about 45 other companies with products in the marketplace.

Figure 2: Average Net Expense Ratio by Fund Provider

Average Net Expense Ratio by Fund Provider

Source: Morningstar Principia through June 2013

There are other low-fee providers not on the list, such as Charles Schwab. They are building assets and increasing their offerings, but still remain a minor league player. Perhaps they will be on the list in a few years.

Overall, the next generation of ETPs is likely to have higher fees. Actively-managed ETF issuance is set to grow in the future as traditional fund providers expand their methods of product distribution.  The expense ratios of actively-managed funds are always higher than low-cost index tracking funds, although offering active management in an ETF will likely save money for investors who are otherwise paying for it in traditional funds.

Assets will continue to flow into the ETPs and this will drive more fund companies to enter the space. I expect products to become increasingly complicated and fees to continue to creep higher. The bet is that as money shifts to ETPs, some is going to end up in the coffers of the more expensive products. That’s probably a good bet.