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One of the often-repeated benefits of investing via ETFs is that the costs are a lot lower. In their most recently released annual study on fees, Morningstar found that the average expense ratio paid by investors is half of what it was two decades ago. At the end of 2020, the asset-weighted average fee was 0.41% pa, with much of this decrease being a result of investors preferring ETFs as their investment vehicle of choice.

 

The Morningstar U.S. Fund Fee Study

 Morningstar conduct an annual study on the fees of all US open-end mutual funds and exchange-traded funds. The results of this study were released the following August with the last study’s data showing some interesting trends. 

The chart is pretty busy so here’s a quick explanation on how to read it: 

  • Any mutual fund or ETF that tracks an index is classified as ‘passive’ while ‘active’ refers to those remaining funds where the fund doesn’t track any index. ‘All’ is the aggregate of all active and all passive funds and ETFs.
  • Equal weighting is the average of the fees of all the funds. Asset weighted (shown as ‘Asset Wt’ in the graph above) is where the size of the fund is critical. The larger the fund, the greater the impact it would have on the weighting.

This graph highlights 30 years of history, tracing back to 1990, and demonstrates that the overall trend is a decline in fees. There has been huge pressure on fees in the fund management industry for well over a decade now and the resulting decline is evidenced by every line in the chart taking a downward trajectory.

If we focus on the equally weighted lines, we see that the average fee for active funds is just over 1.04%. The average fee for passive (incl. ETFs) is 0.45% pa. The passive funds on average charge less than half of the active managers. The largest ETFs charge significantly less as evidenced by the asset-weighted expense ratio for passives being 0.12% pa. The lower-cost ETFs typically enjoy the lion’s share of the inflows.

 

So why are ETFs cheaper?

The vast majority of ETFs track an index, and index tracking is by its nature less expensive than active management. Active managers need a well-staffed team of portfolio managers and research analysts to perform detail calculations on the companies that may be on their investment radar. Index tracking doesn’t require the same level of manpower as the mandate of the ETF is to replicate what is in the index – something that can often be achieved by technology these days.

 The saving on resources does extend further though. The nature of the products themselves have a different amount of work that is required just to bring in new investors. 

 When a mutual fund receives an application from a new investor, it has a lot of work to do. First, the application needs to be processed, opening an account in the name of the investor and recording how money was deposited with the firm. The fund house, through this process, also needs to send out confirmation documents and handle any compliance issues.  Second, once the money that was deposited is recorded, then the portfolio manager needs to go into the market and invest that money, buying and selling securities and paying all the necessary spreads and commissions involved.

 When investors sell, the process works in reverse. Managers sell; funds get disbursed; and so on. As one can see the process is a hands-on, resource-intensive process.

 With ETFs, it’s far easier. When investors want to buy or sell shares of an ETF, they simply enter an order with their stockbroker and… that’s it.

 For most investors, ETF trades take place with other investors, and not with the ETF issuer itself. That means the ETF issuer doesn’t have to process any order as the investors transact between themselves on the stock market. It is an identical situation for a company whose shares are listed on a stock exchange – just because Investor A, sells to Investor B doesn’t change the business of the company – it just changes who has a stake in the business.

 Less work equates to less staff and thus lower costs, which ultimately can be passed onto the investor as lower fees. Fees erode returns and by investing in a product with lower fees you can reduce the impact of this erosion.

  

Magwitch Offshore is a leading provider of Global Balanced ETF portfolios with products in all major currencies. Magwitch utilises an advisor distribution model and their portfolios are available through offshore endowment structures provided by some of the larger Insurers.

 

This article was first published on FAnews:

https://www.fanews.co.za/article/investments/8/etf-s-exchange-traded-funds/1132/why-etfs-are-so-cheap/33306