THE BATTLE between the world’s two largest exchange-traded funds has reached a pivotal moment. On February 18th VOO, an ETF tracking the S&P 500 that is managed by Vanguard, a giant passive-investing firm, took the crown as the world’s largest. Days later SPY, an ETF managed by State Street Global Advisors, another giant, reclaimed it. Both funds boast assets of over $620bn.
For retail investors, exchange-traded funds, and the index-tracking investment they facilitate, are the greatest development in modern financial history. ETFs emerged in the 1990s and provide a way to circumvent expensive fund managers. Liquid and low-fee vehicles have saved investors trillions of dollars. SPY was America’s first ETF and charges fees on assets of just 0.09% a year. VOO, which was set up in 2010, has undercut its rival with fees of 0.03%.
While the Godzilla and King Kong of the ETF universe duke it out, offering ever lower fees, investors looking at more recent offerings have cause for concern. New American ETFs advertise fees just 0.2 percentage points below more expensive mutual funds, down from 0.7 percentage points in 2014, according to Morningstar, a data provider. And fees on new ETFs are rising, rather than falling, as had been the trend for decades. Most funds established in the past few years have fees of 0.5% or higher.
So is the party over for retail investors? The answer will depend on their tastes. If they still prize the cheapness and exposure to big markets first offered by the ETF industry, there is no reason their fees cannot keep falling. A handful of the very largest vehicles have gathered an extraordinary quantity of investor funds: the largest 15 equity-focused ETFs contain $3.9trn in assets, more than the next 100 combined, which in turn hold more than the next 1,000 combined. This scale lowers fees. The larger a fund, the more it can spread fixed costs for trading, management, and legal and regulatory matters. According to Citigroup, a bank, half of American ETFs probably lose money for their issuers because they are not large enough to cover these sorts of costs.
The new generation of funds do not charge hefty fees just because they lack scale. Although most traditional funds are straightforward, often tracking a single broad index of stocks such as the S&P 500 or NASDAQ Composite, recently created versions tend to be a little more esoteric. Some of the most popular put money into environmentally friendly industries, or stocks with specific characteristics, such as lots of free cashflow. Many are actively managed, rather than passively tracking indices. Others are ludicrous. How about a three-times leveraged bet on Nvidia? Such complexity comes at a cost, and not just to an investor’s sanity.
Investors would be better off avoiding many of the new funds altogether, which would be true even if their fees were not so elevated. Some semi-transparent vehicles, which rarely report assets and come with much higher fees, stretch the logic of an ETF to breaking-point. Heavily leveraged and single-stock funds are better options for traders than long-term investors. Thematic funds tend to follow fads that ought to be eschewed.
Yet investors unable to resist their appeal, thereby encouraging higher fees, hardly undermine the broader industry’s model. On February 1st Vanguard, the apex predator of the low-fee approach, cut expenses on 87 of its funds, reducing its average fee from 0.08% to 0.07%. With $10trn in assets under management—a figure that has doubled since 2018—the company has immense scale. Unlike many of its competitors, it sticks to the sort of bread-and-butter funds that require little management.
Indeed, the megafunds and the new, higher-fee variants are strangely symbiotic. When investors can shift lots of their portfolio into diversified stocks at extremely low fees, they reduce their overall expense ratio, which is what matters for returns. This gives room to invest in pricier, more adventurous options, should they wish to gamble. The lower the very largest group of vanilla ETFs are able to push their fees, the more investors can allocate to novel bets.
If average fees start to plateau, therefore, it will not be because the limits of such funds have been reached. Rather, it will reflect the fact that a growing number of investors are opting for products that are less mainstream. If they instead stick to the more vanilla offerings, and avoid the range of increasingly zany ETF flavours, there may still be trillions of dollars in savings to be made in the years to come. ■
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