By Christian Magoon
CEO and Founder, Magoon Capital
The ETF industry had another dynamic year in 2012. The industry continued to evolve on many fronts as increased competition and inflows into ETFs continued to provide fuel for change. Investors were the big winners as lower costs of ownership came primarily in the form of reduced expense ratios. Looking ahead to 2013 however, appears to point to even more fee cuts on the horizon. Let's take a quick look at 2012 and then examine why 2013 should be even more promising for cost-conscious investors.
2012 Fee War
The cost of ownership for many ETF shareholders fell in 2012. This year it was primarily due to an expense ratio battle between ETF Sponsors rather than the introduction of limited commission free trading for example. Leading sponsors iShares, Vanguard and Schwab all significantly reduced expense ratios on many core equity ETFs in a bid to gather market share.
For example, the large cap equity ETF space has been hotly contested due to the immense amount of assets invested in this core portfolio component. Indeed the largest ETF in the world, the SPDR S&P 500 ETF (SPY) resides in the large cap core group and is priced at 9.45 bps. The aforementioned ETF Sponsors all aggressively repriced their offerings in this category in 2012 to put more distance between their offerings and SPY. Meanwhile SPY remained content with the enviable combination of the largest assets and the highest fees of the four ETF Sponsors. Here's a chart displaying the current expense ratios of Schwab's SCHX, Vanguard's VOO, iShares' IVV and the SPDR ETF, SPY. This data is from Index Universe.
Besides large cap core equity ETFs, areas as diverse as gold mining and India-focused ETFs also saw meaningful price drops in a bid to compete on price.
Yet even though 2012 has seen its share of cost reduction, 2013 could yield an even larger step forward in the reduction of ownership costs for ETF investors. Two developments are emerging on the ETF Sponsor side that may pave the way for even more aggressive pricing in 2013.
First, many ETF Sponsors are now in the process of transitioning from only being able to track third party indexes with their ETFs to having the freedom to create indexes internally. So called "self indexing" allows ETF Sponsors to create and track their own indexes. The ability to do this requires special permission from the SEC and a demonstration of proper separation of the index and asset management businesses within the company.
Self indexing is appealing to ETF Sponsors as it allows them to have more control over the pricing of the indexes their ETFs track. ETF Sponsors with this option have the ability to select between third party index pricing or the cost of developing their own. For ETF Sponsors with scale it leads to cost savings that could be passed on to investors. ETF Sponsors including FlexShares, ProShares, State Street, Market Vectors, BlackRock's iShares, Guggenheim, WisdomTree and Index IQ are either self indexing some products already or have filed for the ability to do so. Self indexing will become more common in 2013 and increase the ability for ETF Sponsors to offer lower ETF expense ratios.
Second, it appears that commission free ETF access could be coming to investors in a broader format. Currently several brokerage firms are partnering with select ETF Sponsors to offer a small amount of ETFs on a commission free basis. Remember, just like purchasing a stock, one cost of ETF ownership is the trading costs associated with buying and selling the ETF. Losing that cost, especially for investors who may be dollar cost averaging, is significant but should not be the driving factor in ETF selection. This is especially true given the rather meager selection of ETFs currently available commission free. This may all change in 2013, however.
According to several ETF market participants, the creator of the mutual fund supermarket, Charles Schwab, is trying to create a commission free ETF supermarket. This would tear down the commission barrier to ETFs listed on the platform, which could be a significant amount given Schwab's appeal as an asset gathering platform. While there is no official comment on this initiative from Schwab, ETF Sponsors are talking about this privately as a game changer that arrives in 2013. This development would influence a broader move by the brokerage industry for commission free ETF trading, a plus for investors.
While 2012 will be remembered for a series of fee cuts by ETF Sponsors on many core ETFs, 2013 has the potential to upstage it. ETF Sponsors are increasingly looking inward to find economies of scale to pass on to investors. Self indexing is just one example of a method which accomplishes that for larger ETF Sponsors. Meanwhile the brokerage industry is leading the charge to reduce ETF entry and exit costs for investors. Both of these developments point to the potential for a banner year of cost reductions for ETF investors in 2013.