The Price Can Go to Zero

For many years, the fees charged by investment managers of mutual funds grew ever so slightly, gradually approaching 1.5%. Over the last few years, though, the growth in these management fees has stopped. In fact, it reversed. Last year the average management fee charged for actively managed mutual funds was 1.38%, or 138 basis points, where a basis point is one tenth of one percent. But that average is badly misleading. It’s misleading because it treats all funds, regardless of size, as the same. When you adjust the fees for the size of the funds, you find that the dollar-weighted average for actively managed funds is now below 100 basis points. Three things have caused this reversal in management fees: low returns in the stock market, the growth of exchange-traded funds (ETFs) and a price war among the biggest players in the market.

The first two of these factors need little explanation. Over the last ten years, an investment in many bond funds out-performed an investment in diversified equity funds. These low returns have many investors focusing on the costs they incur for the management of their money. These costs include transaction fees for trading securities and management fees for the companies managing mutual funds or exchanged-traded funds. The second factor, the growth of ETFs, is somewhat less obvious, but important. ETFs have garnered a significant share of new money invested in equity funds over the last few years. Companies managing ETFs charge low fees for managing these funds because they have very low costs for shareholder servicing and some other administrative functions associated with investment management. Shrewd mutual fund managers have reduced prices in order to manage the gap in pricing they allow for their managed mutual funds compared to comparable ETFs.

These two causes of the fall in prices for investment management now have a third important factor. This third factor may turn out to be the most important of all. (See the Symptom & Implication, “The industry is seeing its first price wars” on StrategyStreet.com.) As described in other blogs (see blogs HERE and HERE), Vanguard has started, and continued, a price war in the ETF market. For example, iShare’s MSCI Emerging Market’s ETF and Vanguard’s Emerging Market’s ETF compete directly. Vanguard’s fund charges 27 basis points. The iShare’s fund charges 69 basis points. The iShare’s fund entered the market well before the Vanguard fund, and was much larger than the Vanguard fund. However, during 2010, the Vanguard ETF added $18 billion to its fund while iShare’s added about $4 billion. Price matters among peers.

The iShare’s funds are not always market share losers, however. The iShare’s Gold Trust is an ETF that competes with a larger rival, SPDR Gold Trust. Until June of last year, both of these ETFs charged 40 basis points. In June, iShares cut its management fees to 25 basis points. SPDR Gold Trust stayed pat at 40 basis points. Over the next few months, the iShare’s fund gained $875 million in new money, while the SPDR Gold Trust saw a net loss of $1.2 billion of money under management. Price matters among peers.

These management fees can even go to zero. One ETF today has no management fee, zero. It gets its revenues by lending out the securities in its portfolio. (See the Symptom & Implication, “Technology improvements bring falling prices” on StrategyStreet.com.)

Of course, as companies engage in price wars, they advertise their lower prices extensively in order to capture as much market share as possible before their competitors respond. The result: customers are becoming ever more price sensitive about the management fees they pay, simply because the management companies tell them to be more sensitive.

How long will it be until this fee warfare spreads to other smaller types of ETFs? Not very long, as long as price moves share.

The ETF Arms Race

In our previous blog (See Here), we discussed Vanguard and its unseating of Fidelity as the largest money manager in the U.S. Vanguard has done this with low-priced attacks on virtually every market Fidelity serves. Fidelity, and much of the rest of the market, is allowing Vanguard to get away with this, at least for now. In this blog, we want to see how pricing affects even a fast-growing market and then watch what happens when a Vanguard flexes its muscles in such a fast-growing market.

Exchange Traded Funds (ETFs) are some of the hottest products in the financial industry today. They are cheaper and, often, more tax efficient than are mutual funds. Because of these advantages, many independent registered investment advisors and individual investors have shifted out of mutual funds and into ETFs. The ETF market is growing rapidly.

A year ago, Schwab decided to take share in this market by using low prices. Schwab offered eight ETFs to its customers on a commission-free basis. Since Schwab is such a leader in the market, the company’s move started a war. (See the Symptom & Implication, “The industry is seeing its first price wars” on StrategyStreet.com.) In short order, E-Trade, Fidelity and Vanguard joined the fray. Fidelity offered twenty-five iShares ETFs, commission-free. Recently, TD Ameritrade upped the ante. This company offered more than one hundred ETFs, commission-free, to both individual investors and investment advisors. This is a real arms race in the fast-growing ETF market. Prices on already inexpensive ETFs continue to fall.

Why this focus on industry prices? The industry has learned that high prices cost you market share. This is a sure signal that customers are having increasing difficulty making buying decisions among the top industry ETF providers on the basis of Function, Reliability or Convenience. When an investor can not chose among peer competitors on the basis of performance, that is Function, Reliability or Convenience, they make their decisions on the basis of Price. (See the Perspective, “What Ends Hostility” on StrategyStreet.com.)

In this price war, Vanguard stands to gain the most, at least in the short term. This company is well known for its low-cost funds. So far this year, Vanguard has garnered 37% of the new money coming into the ETF market. Their 37% share of new money is greater than the combined shares of the two biggest ETF companies, iShares and State Street Global Advisors, combined.

For their part, the top two ETF sponsors argue that they will not be drawn into a price war. This is simply a Leader’s Trap. You can ignore these protestations. They, and everyone else in the market, will have to respond to Vanguard, or stand aside and watch Vanguard trample them in the market.

Investment Turf Wars

Over the last year, U.S. investors have pulled over $20 billion out of domestic stock funds and replaced these investments, in large part, with bond funds. Not every type of stock fund suffered, however. The February 2010 data illustrate this. Domestic stock funds, during that month, suffered $3.7 billion in withdrawals. On the other hand, international stock funds gained $4.6 billion. But the big winners were domestic Exchange Traded Equity Funds. They gained $4.8 billion. These ETFs are attracting investors with their very low costs in management fees and superior tax efficiency over the average mutual fund. Their growth is also an indication that investors have become more price-sensitive than they have been in the past. (See the Symptom & Implication, “Customers are more price sensitive” on StrategyStreet.com.)

There is another interesting example of this emerging price-sensitivity in the potential for something of a price war among similar ETFs. In particular, there are two ETFs which seem to be squaring off against one another. One fund, iShare’s MSCI Emerging Markets Index Fund (EEM) is the dominant leader among ETFs that attract emerging markets. A growing follower is Vanguard’s Emerging Markets ETF (VWO).

The approach and results from both funds are similar. Each fund tracks the same index, the MSCI Emerging Markets Index, though they follow somewhat different approaches in tracking that index. Over the last five years, both funds have had similar returns on investment after consideration of price appreciation and dividends.

Despite their similarities, the two funds today show radically different appeals to investors. Over the last three months, EEM has experienced $4.4 billion in net outflows. In contrast, VWO has had $8 billion in net inflows over the same period of time. This $12 billion difference flies in the face of the fact that EEM today has over $39 billion under management, while VWO has $21 billion.

The apparent explanation? Pricing. The prices of these two similar ETFs are different. EEM charges 72 basis points (a basis point is 1% of 1%, so 50 basis points is equivalent to half a percent, or .50%). VWO, on the other hand, charges only 27 basis points.

The competitive landscape may be changing for these two very large ETFs. For most of the last five years, they did not bump into one another with great frequency. EEM concentrated on the institutional market, while VWO sought the hearts of retail investors. That may be changing. As markets grow fast, sooner or later companies in similar niches begin running into one another. (See the Symptom & Implication, “Competitors in formerly underdeveloped markets have begun meeting one another” on StrategyStreet.com.) Witness Lowes and Home Depot, Staples and Office Max and Office Depot. When that happens, pricing begins to play a more important role in the battle equation between the two competitors.

Over the last few years, investors have developed a clear preference for inexpensive ETF funds rather than actively managed mutual funds. Now that low-price preference also seems to be showing up in competition among ETFs. Investors will surely be the winners here.

A Concentrated Industry

Over the last few years, the exchange traded fund (ETF) business has exploded as the advantages of exchanged traded funds attract investors away from individuals picking stock or investing in mutual funds. (See "Audio Tip #1: Defining a Business” on StrategyStreet.com) The industry manages nearly three quarters of a trillion dollars in assets.

Many fast-growing industries are not highly concentrated. This industry is concentrated. The top three providers control 84% of assets under management. In the average industry, it takes about four competitors to control 84% of the industry (see Benchmarks/Market Shares on StrategyStreet.com).

The ETF industry leader, by far, is BlackRock. BlackRock recently bought the iShares operation from Barclays Global Investors. It bought a very successful business. BlackRock manages 49% of the assets invested in ETFs. This compares with the median number one player in an industry at 39% market share.

The second player in the industry is State Street Global Advisors. This company has a 23% market share. Their 23% compares with the median number two competitor in an industry with 18%.

The third player in the ETF industry is Vanguard. Vanguard owns a 12% market share. This market share is not far off from the average number three competitor in an industry, at 11%.

From the share statistics, it is clear that the unusual concentration in the ETF industry rests primarily with the top two players.

These share concentration ratios for the ETF business may fall over the next few years. New competitors are pouring in the door, offering alternative ETF vehicles. But the big changes are likely to come from Charles Schwab. Charles Schwab has begun offering ETFs with commission-free trading, in other words, lower prices.

As fast-growing industries develop, their early stages witness a predominance of Function innovations, where companies offer something new for the user of the product. As the innovations in Function begin to wane, fast-growing industries witness more price-based competition. This price-based competition then leads to a period of shake-out in the developing industry. (See “Audio Tip #34: How Does a Company “Win” in a Market?” on StrategyStreet.com.)

It looks like Charles Schwab has fired the first major shot in this price-based competition in the ETF business. It should be an interesting battle. (See the Symptom & Implication “The industry is seeing its first price wars” on StrategyStreet.com.)