(Bloomberg) -- If something sounds too good to be true, it probably is.
There’s a dark side to the wave of cost cutting that’s swept through the exchange-traded fund industry over the last 12 months. While every mom and pop in America can now pay nothing to buy an ETF through their favorite broker, and an extra nothing to cover its annual management fee, concern is mounting that there are catches to this bargain that could surprise investors.
Brokerages have been fairly upfront about compensating for their lost commissions with interest revenue, but managing a fund -- even one that tracks an index -- isn’t free either. It costs about $250,000 per year to run an ETF, with the exact amount depending on what the fund owns, which service providers it hires, and the issuer’s broader business. But one way or another, whether its legal costs, aggressive up-selling or extra risk-taking, investors could wind up paying.
“This isn’t UNICEF, there’s a cost associated with doing things,” said Matt Bartolini, head of SPDR Americas Research at State Street Global Advisors, referring to the well-known children’s charity. “My first question is how are these costs being covered?”
The answer? It depends. A fund’s management fee typically covers the cost of licensing or creating an index, admin like record keeping and prospectus mailings, as well as the expenses associated with running a board of directors. Issuers that offer products for free still have these costs, but they have more reason to try to reduce them.
One place where efficiencies could be made is in the legal department, which could hurt investors in the event of a lawsuit. Other savings could be made by constructing indexes in-house or licensing lower-cost alternatives, hiring second-tier custodians, or limiting any sales presence or advertising budget. These economies could result in damaging oversights, or increase the likelihood of the fund closing.
“I would be concerned about the compliance and legal aspect,” said Sam Huszczo, the founder of SGH Wealth Management, a $170 million investment adviser based in Detroit that uses ETFs. “Those are the two areas where I could see corners being cut.”
Salt Financial, which pays investors to buy its fund, tracks an index of stable companies and only swaps out two or three names per quarter, which lowers transaction costs, according to co-founder Alfred Eskandar. In October, the company said it planned to move the ETF to a trust maintained by U.S. Bank to reduce administrative and operational complexity. The change will also save money, although Eskandar said investors will not be exposed to additional risks. He hopes the lack of fee will encourage investors to try the fund, and that they’ll stick around due to its performance.
An alternative strategy for issuers with more than one product is to leverage their zero-fee products to generate other business. Fidelity Investments started the first zero-fee mutual funds in August 2018, but they’re only available to investors that have a brokerage account with the firm. Meanwhile, Social Finance Inc., an online lender best known for refinancing student loans, views its no-fee products as a way to develop existing clients. Two of its ETFs cost nothing until at least June 2020, but another fund costs $5.90 for every $1,000 invested, more than the median ETF fee.
The thinking was “we’ll provide this for free so you can find out all the other things available in this community,” said Michael Venuto, chief investment officer of Toroso Investments, which helped SoFi start its funds. “It’s about engagement,” he said, adding that selling more expensive products alongside zero-fee ETFs is not nefarious.
A greater risk looms as these funds grow. ETFs habitually lend out a proportion of their holdings to hedge funds and other borrowers for a fee, part of which goes back to investors. While the amount of securities that can be out on loan at any given time is capped by the regulators, issuers of zero-fee funds could be incentivized to lend out a larger portion of their underlying portfolios, and keep a larger percentage of the profits.
While no zero-fee ETF currently engages in the practice, Fidelity’s four index funds are eligible for securities lending, according to a company spokesman. But all revenue -- minus lending agent and custodial fees -- goes back to investors. ETFs need about $50 million to make securities lending worthwhile, according to Toroso’s Venuto, who says it’s low risk.
Still, the race to zero shows no sign of letting up. Abolishing fees generates publicity, something that could make the difference between survival and liquidation in a marketplace with more than 2,000 options. More than 70% of U.S. ETF assets are in funds that charge $2 per $1,000 invested or less and 93% of new money has flowed into such products this year, according to data compiled by Bloomberg.
Vanguard Group cut its fees again on Oct. 23, this time announcing that it would reduce the cost of 13 London-listed ETFs. Meanwhile, in the U.S., BNY Mellon has filed for a group of broad-indexed ETFs, fueling speculation that these products could augment the growing pool of zero-, or near-zero, fee investments.
“If they’re not getting paid by the clients, how are they getting paid?” Dan Egan, managing director of behavioral finance and investing for Betterment, said of zero-fee funds. “People who are happy paying nothing for something are going to get what they pay for.”
To contact the reporter on this story:
Claire Ballentine in New York at [email protected]
To contact the editors responsible for this story:
Jeremy Herron at [email protected]
Rachel Evans, Rita Nazareth