Memo To Fink On iShares Fees

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A week ago, Bernstein Research put out a note predicting fee cuts for a host of iShares products in the coming months. Bernstein argued-and I think rightfully so-that comprehensive cuts would be both unlikely and foolhardy.

After all, why apply a wholesale cut to your product line when you have hugely popular funds-the iShares MSCI Hong Kong Index Fund (NYSEArca:EWH) and the iShares MSCI Taiwan Index Fund (NYSEArca:EWT) come to mind-are operating in what are essentially one-fund segments?

A massively strong brand could clearly be diluted with such a "bargain basement" campaign.

A more measured response that leverages the firm's massive pipeline of market knowledge, research and customer feedback to forecast the expected impact of fee cuts is a much more reasonable approach.

Then, almost on cue, after hinting at it during July's quarterly earnings call, BlackRock Chief Executive Officer Larry Fink said on Monday that iShares would be cutting fees on some of its core-strategy funds in the next three months.

Nobody but Larry and the good folks at BlackRock know what those "core funds" are, but I think three obvious funds stick out.

EEM, A Clear Candidate

The iShares MSCI Emerging Markets Index Fund (NYSEArca:EEM) is the Intel of the ETF market. Much like the tech giant, EEM broke on the scene with a revolutionary product that opened the world to investors.

Like Intel, competitors came along with products that eventually commoditized the groundbreaking iShares fund. What was once exotic exposure-emerging markets-is now in every investor's daily vernacular.

When Vanguard had the gall to move into the emerging space with a fully replicated fund tracking the same index as EEM-and at less than half the cost to boot-the multibillion-dollar behemoth began losing out to Vanguard in the asset-gathering war. For the record, EEM now costs 0.67 percent, while VWO costs 0.20 percent.

Articles were written, poor tracking was highlighted and eventually the Vanguard MSCI Emerging Markets ETF (NYSEArca:VWO) surpassed EEM in assets, and hasn't looked back since.

To its credit, iShares evolved, eliminating its optimization strategy and decreasing fees. The problem was Vanguard's fees were also falling. Now, with eight different emerging markets funds with cheaper expense ratios-including the iShares MSCI EMEA Index Fund (NYSEArca:EEME), a more narrowly focused iShares product-it's getting harder and harder to justify EEM's lofty 0.67 percent annual expense ratio, especially with the fund's volatile tracking. The pressure is on for a fee cut on EEM.

Bond Funds Like AGG As Well

The iShares Barclays Aggregate Bond Fund (NYSEArca:AGG) is a massively popular fixed-income product for iShares that actually carries tighter average spreads than its competitor, the Vanguard Total Bond Market ETF (NYSEArca:BND). It's less than a basis point lower than BND's spread, but it is nonetheless lower.

The problem is BND's portfolio is half the price of AGG-10 basis points vs. 20 basis points-meaning the round-trip cost is roughly half the cost of AGG. Once again, iShares is charging twice as much as Vanguard to track the exact same index.

Sure, AGG has been less volatile in tracking the Barclays Capital U.S. Aggregate Bond Index by a wide margin in the past two years, but many investors who aren't privy to the high-level presentations of BlackRock representatives explaining tracking error will see the higher headline expense ratio, calculate the higher round-trip cost for AGG, and simply choose BND.

Sector Funds Too

Sector funds are another category where iShares should be looking to cut prices, though this one is a bit more complicated because different classification systems can cause differences in exposure that allows firms to position their products as unique.

Unlike EEM and AGG, which have become commoditized, the sector products still have points of differentiation.

Take IYM, the iShares Dow Jones U.S. Basic Materials Index Fund (NYSEArca:IYM). Since it tracks the Dow Jones U.S. Basic Materials Index, which is based on the Industry Classification Benchmark ( ICB ) as opposed to, say, the Vanguard Materials ETF (NYSEArca:VAW), which tracks the Global Industry Classification System (GICS)-based MSCI U.S. IMI Materials Index, the iShares fund includes coal firms, which GICS classifies as energy.

Then there are funds like the SSGA Select Sector SPDRs, which only pull from the S&P 500 Index. These portfolios have narrower coverage than the iShares Dow Jones sector funds. Distinctions like these cause exposure differences, which lead to differences in returns, which ultimately lead to selling points.

The problem is, despite the fact that these exposure differences are not trivial, they're not enough to justify the 29 basis point difference between the iShares suite of funds and those on offer from SSgA.

In the end, I don't claim to know the intimate details of the cost structure of running each iShares ETF.

What I do know is that fee cuts are coming, and these funds are the obvious candidates. Either way, this is good news for investors.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: AGG , EEM , EWH , ICB , IYM

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