2018 was a turbulent year for the financial world. Stocks tumbled dramatically in the last portion of the year, pessimists called for a recession in the near future, new industries sprouted, grew, and perhaps oversold themselves. There is at least one area of the investment landscape that has been relatively stable in terms of overall inflows and growth, however: ETFs. Exchange-traded funds saw inflows of more than $280 billion last year, marking the third year in a row in which the low-cost mutual fund alternative grew by at least $250 billion.
Along with the continued expansion of the ETF space with regard to assets, the number of exchange-traded funds has kept growing as well. As the number of ETFs available to investors has climbed into the thousands and as funds have grown increasingly specific with regard to focus, competition among rival issuers has heated up. One way that many funds have tried to entice investors away from their rivals is by lowering investor fees. Now, at the outset of 2019, the ETF space is nearing a crucial landmark; this year is likely to see the first zero-expense-ratio ETFs become available to customers.
Race to the Bottom
The fee that an ETF issuer charges to a client, known as the expense ratio, has long been one of the major draws of this type of fund. In stark contrast to, say, hedge funds, which are known for charging management fees of 2% in addition to a 20% cut of all profits, ETFs routinely charge expense ratios significantly less than 1%.
With more and more ETFs vying for customer dollars, some funds have aimed to undercut competitors, and the result has been a steady lowering of ETF expense ratios. Indeed, per a report by ETF.com, there are currently 11 U.S.-based ETFs which charge just 0.04% in an expense ratio. There are five more funds charging just 0.03%. To get a sense of just how meager those fees are, they amount to $4 or $3, respectively, for every $10,000 invested. Many of the lowest-cost ETFs are provided by major issuers like Vanguard, Schwab and iShares. These firms can take advantage of their massive volumes in order to price their fees lower than competitors with smaller reach.
A Look at the Cheapest ETFs
Can the 16 ETFs indicated above really prove successful for their issuers, even with expense ratios that low? The providers have hoped to compensate in increased volume, and so far, customers seem to be interested. Those 16 ETFs charging $4 or less per $10,000 invested drew in more than $62 billion in net inflows in 2018. In a field of thousands of funds, this small pool brought in nearly a quarter of all new cash.
Could all of this be pointing to an ETF landscape in which fees continue to drop? It seems likely. A closer look at a couple of the existing ultra-cheap (but not free) ETFs reveals just how demanding customers can be. Take the Invesco PureBeta MSCI U.S.A. ETF (PBUS). This fund is about 15 months old as of this writing and sports an expense ratio of just 0.04%. However, PBUS has under $3 million in total assets, even though it outperformed its competitor, the Schwab U.S. Large-Cap ETF (SCHX), by about 300 basis points across most of 2018. SCHX, by contrast, added about $3 billion in new money in 2018 alone. It's easy to imagine Invesco trying to shift the flow of assets by launching a new ETF with a lower expense ratio than SCHX.
Issuers like iShares and Vanguard have brushed aside speculation that a zero-fee ETF is likely to emerge in the near future. Fidelity has already moved into the zero-fee fund space with index mutual funds; the company launched four such funds in 2018. However, these are currently only open for investment to Fidelity brokerage clients.
A major issuer like Schwab could eliminate the fee from one of its popular, low-fee ETFs without losing much from its annual revenue stream. Indeed, the benefits, including higher trading volumes and asset growth rates, could outweigh the revenue lost by zeroing out the expense ratio. On the other hand, an up-and-coming issuer angling for a spot among the major players in the ETF space could draw significant attention by becoming the first to offer a no-fee ETF. Eithr case is fairly easy to imagine at the outset of 2019. The question may not be whether or not a zero-expense-ratio ETF will arrive this year, but rather which issuer will get there first. It's likely that the arrival of the first no-fee ETF will inspire a significant change across the larger ETF space. Once ETFs begin to charge 0% expense ratios, though, how will issuers differentiate their products from their competitors' funds?