How Fee Compression Is a Blessing and a Curse for ETF Managers

For the first half of 2018, three exchange-traded fund (ETF) issuers in the U.S. captured more than 80% of all net U.S. ETF inflows. These three – BlackRock, Inc. (BLK), Vanguard and The Charles Schwab Corporation (SCHW) – have asset-weighted average ETF expense ratios of just 0.16%.

In the ETF space, the expense ratio is one of the most significant considerations that investors consider when determining where to invest. The space has grown tremendously in recent years, and competition has gotten fiercer in the process. At this point, ETFs have to keep expense ratios at a shockingly low level if they hope to compete with a growing field of rivals.

Below, we'll explore some of the reasons why this fee compression is both good and bad for the space overall. (For more, see: When Is an Expense Ratio Considered High and When Is It Considered Low?)

According to ETF.com, when one looks closer at the top three U.S. ETF issuers, it becomes clear that 0.16% is not even particularly accurate as an expense ratio standard. Vanguard, which captured 32% of ETF assets, has an average expense ratio of 0.07% on an asset-weighted basis. Charles Schwab, which stunningly brought in 13% of flows despite controlling just 3% of the total assets at the beginning of the year, has a fee of 0.09%. BlackRock actually lost market share; it had 39% of ETF assets at the start of the year but fell when it brought in only 36% of net ETF flows. Part of the reason for this is the fact that BlackRock's average expense ratio is 0.22%. (For related reading, check out: Guide to ETF Providers.)

As expense ratios get lower, ETF managers are feeling the squeeze in many areas. Investors today expect that portfolio management will essentially be free. ETFs that could have previously maintained market share by offering top liquidity are struggling to compete with cheaper rivals. With investor money continuing to flow primarily to those ETFs seen as the best value, there is increasing pressure for all players to lower their fees.

According to the ETF.com report, for the first half of the year in the U.S. ETF space, those products gaining market share within their segments tended to cost just 0.19% on an asset-weighted basis, while those losing market share cost 0.27%. Lest this margin seem slim, it's worth noting that market share gainers actually cost just 0.1903%, an even smaller difference from 0.1912% at the end of last year. As the report suggests, "every basis point in expense ratio increases the risk of irrelevance or failure, unless there is no competition in that particular space."

As a result, funds can no longer rely on finding a market niche. As soon as cheaper competitors enter the market, it has become a race to the bottom in terms of fees. One of the most popular ETFs, the SPDR S&P 500 ETF Trust (SPY), has actually lost more than $21 billion in assets during the first half of the year, with many of those assets going toward cheaper competitors. (See also: What's Causing the ETF Price War?)

The benefits of fee compression may seem to be heavily weighted toward the investor. However, low fees across the ETF space have also helped ETFs to grow as quickly as they have. In comparison with mutual funds and actively managed products, ETFs offer much better fees as a group. However, what began as a draw for the ETF space relative to other types of products may have come back to bite fund managers. Investors continue to press ETFs to lower their fees, and it seems likely that expense ratios will eventually be driven down to zero, or at least to the lowest possible level to cover operating costs. (For more, see: Pay Attention to Your Fund’s Expense Ratio.)