Head of Research
A New Low-Rate Environment
In recent years, investors have placed particular emphasis on the low interest rate environment, and its implications for the portfolio. Not to diminish monetary policy, but there may be another low-rate environment that has not garnered sufficient recognition, the emerging low fee ecosystem in investment funds coinciding with the rise of Exchange Trade Funds (ETFs).
Since 2005, U.S. investors saved an aggregated $266.5 billion from the new paradigm of decreasing fund expense ratios. To put this sum into perspective, these accrued savings are more than the entire annual economic output of the state of Oregon, and the annual savings roughly equal to the output of Montana. What follows is analysis of the array of dynamics that have enabled this fundamental redistribution of wealth, namely from investment managers to end clients, from Wall Street to Main Street.A Tale of Two Funds
This low fee environment represents a massive windfall for investors, driven in no small part by the proliferation of Exchange Trade Funds (ETFs) and indexing strategies. The management fees for these products are on average 65.1% lower than those of mutual funds, and this cost analysis ignores the additional impacts of sales charges and potential tax efficiencies.
One of the better ways to understand the magnitude of these savings is to identify the market factors that have precipitated them. The chart to the right depicts several of these dynamics at work, foremost a shift in the relative balance of power between mutual funds and ETFs in terms of assets. In addition to this net asset migration between funds, a second impactful trend is the decreasing cost structures of both fund types. These two separate, but complementing effects, carry significant explanatory power as to the origin of these investor savings.Modeling an Investment Windfall
The second chart breaks down the impacts of these two trends, asset migration and rate reduction, and it also details the economic basis of these billions in savings. Note the blue shaded area, which represents the historical investor savings on management fees expressed in basis points, as beginning in 2005. The lower bound denotes the effective expense ratio covering both mutual funds and ETFs, reflecting management fees paid across all funds divided by total assets. With the upper bound extending the 2004 effective rate, the difference reveals net savings made available to investors through this financial innovation.
This enclosed region, therefore, encapsulates the fees investors would have paid had these two dynamics not reconfigured the financial landscape in the form of a low rate revolution. From this second chart we can deduce that the low rate-environment is essentially massive rebate apparatus, reducing investor fees by 30.6% over the course of a decade, rewarding investors to the tune of $44.20 billion in 2016. As striking as these savings may be, an examination of each dynamic on an individual basis lends a fuller understanding of these structural shifts.
Dynamic 1: Asset Migration and Growth Divergence
Foremost, the asset migration dynamic covers how owning more ETFs relative to mutual funds has produced investor savings, ignoring the impact of decreases in expense ratios. The second figure depicts just how dramatic this effective migration has been, with the ratio of mutual fund assets times over ETF assets decreasing from 49.01 in 2003 to 6.48 in 2016, an 86.8% decrease. This transformation largely devolves into a story of divergent growth patterns between the two fund types.
To this end, ETFs have attracted assets at an astounding rate. U.S. listed funds in particular have increased assets nearly 6-fold from 2006 to 2016, for a 10 year CAGR of 19.6%.
Global ETF assets expanded similarly, growing 553.8% over the same time period for a 20.7% 10 year CAGR.
In marked disparity, mutual funds have not paralleled this marked increase in assets, with historic growth rates broadly decelerating before turning negative in 2015. Contrasted against the several times growth of ETFs, U.S. listed mutual funds only increased by 57.5% from 2006 to 2016, for a relatively paltry 10 year CAGR of only 4.7%. This slowdown became particularly pronounced in the last 2 years, as ETFs gained assets at 8.42 times the rate of mutual funds.
A metric that drives home this growth disparity is that for every 1.00% annual growth rate in ETF assets, not only has mutual fund growth decelerated by 0.971%, but this deceleration increased by 1.31% annually. All calculated, the shift of relative ownership in favor of ETFs has accounted for $47.77 billion in savings, 17.9% of the total sum. Although this level of attribution may initially seem low, an important consideration is that ETFs in terms of assets, even with this migration, are still very much the junior partner to mutual funds.
Dynamic 2: Rate Reduction
While asset migration from mutual funds to ETFs alone does not account for the bulk of the low fee savings, it introduces the secondary effect of induced rate reduction. The popularization of less costly ETFs appears to have pressured mutual funds to cut their own management fees, and to do so sharply. This rate reduction dynamic therefore explores how this decrease in fees, holding the balance of ETF and mutual fund assets constant, has yielded investor savings.
The initial chart illustrates how the weighted average of mutual fees, depicted by the red line, decreased by 26.01% from 2004 to 2015. Certain categories of mutual funds experienced even steeper reductions, with equity fund fees decreasing by 28.41%, and money market fund fees dropping by 61.91%. Even the already low-cost passive funds decreased by a further 24.85% over the same time period.
Quite simply, these fee reductions are massive, and they may find their genesis in one of the most potent of market forces, namely competition. Within the ETF space for instance, intense fee-based competition exists where the preponderance of assets gravitate; this dynamic manifests itself in the called race to the bottom. As a corollary, we see that ETFs can sustain higher expense ratios where the asset concentration is lower and the competitive impulse is far weaker.
The data corroborate this competition hypothesis as 37.71% of ETF assets are in funds with fees of 10 basis points or less, and 53.25% of assets in funds in the lowest decile for fees (15 basis points). Overall, the data evidence a 20.54% decrease in fees for every doubling in asset concentration; this is an immensely powerful effect given that ETFs range in assets from $1 million to over $200 billion.
Consumer preference overwhelmingly favors ETFs with inexpensive fee structures, and there may be no reason mutual funds should be immune from this effect. All quantified, the rate reduction dynamic accounts for $218.73 billion in low rate savings, amounting to 82.1% of total savings. For perspective, the impact of these savings is nearly as much as if the largest ETF had all of its assets redistributed as helicopter money.
Investor Implications: A New Finance
With the net present value of savings since 2005 reaching $367.9 billion, the low rate paradigm and ETFs have introduced a fundamental change of calculus for investors, retail and institutional alike. Numerous implications stem from this financial disruption, chief among these a democratization of the tools, instruments, and importantly, gains of finance. The low rate movement squarely changes the focus of investing from meeting the interests of asset managers to those of clients. Backed by intra-day liquidity, not only do ETFs deliver an alternative vision for finance, but they also provide investors the market mobility necessary to realize it.
For instance, if some variation of a fiduciary standard were introduced, would it be ethical to place clients into a high-cost product that is substantively identical to an ETF of lesser expense? This is a discussion the financial industry has yet to seriously entertain, and it touches on the underlying egalitarian nature of ETFs.
Other ancillary benefits to the new economics of the low-rate ecosystem is that diversification is made more accessible and less expensive. Additionally, reduced management fees also help investors offset the meager yields characteristic of today’s low interest rate environment.
Future of the ETF Revolution
As substantial as these savings may be, the ETF revolution may have yet to exhaust its momentum and may be far from market saturation. Foremost, ETFs are currently a primarily American phenomenon given that U.S. listed funds account for over two thirds of global assets; this is a 3,006 basis point overweight. Considering that U.S. listed mutual funds constitute only 50.61% of global assets, there may be opportunity for significant ETF expansion overseas.
Another factor pointing to continued ETF proliferation is that investment funds, whether mutual or exchange-traded, exhibit a resounding popularity among U.S. investors. For instance, the combined assets of ETFs and mutual funds have outpaced the growth in the S&P 500 by 48.5% from 2003 to 2016. Moreover, the current low rate environment only increases the relative attractiveness of investment funds compared to the alternative of single stocks.
Perhaps most striking is that all these savings should accrue, these dynamics materialize, when ETFs currently capture only 13.4% of U.S. fund assets. As of yet ETFs are but a minority shareholder in terms of investor assets; imagine the implications of majority control for ETFs. Does a financial renaissance await? Guttenberg may yet be smiling.