How Can ETF’s Be So Cheap – Too Good To Be True?

By: Pete
Date posted: 09.26.2012 (1:43 am) | Write a Comment  (0 Comments)

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Last week, I received an email about reduced fees for the Charles Schwab ETF’s. Not much news about that as it seems like all issuers are gradually reducing those. What did catch my attention though is how low they’re taking their fees to. For example, both their US Broad market and US Large-Cap ETF’s will now carry a 0.04% annual MER. Yes, you read that right. That is about as close as you can get from 0. Just take a look at the fees they will be charging on their ETF’s:

U.S. Broad Market 0.04%
U.S. Large-Cap 0.04%
U.S. Large-Cap Growth 0.07%
U.S. Large-Cap Value 0.07%
U.S. Dividend Equity 0.07%
U.S. Mid-Cap 0.07%
U.S. Small Cap 0.10%
U.S. REIT 0.07%
International Equity 0.09%
Emerging Markets Equity 0.15%
International Small-Cap Equity 0.20%
U.S. Aggregate Bond 0.05%
Short-Term U.S. Treasury 0.08%
Intermediate-Term U.S. Treasury 0.10%
U.S. TIPS .07%

Too Good To Be True?

I’m the first one to say that when it seems too good to be true, it usually is, especially when it related to finance and the markets in general. That being said, this is one case where it’s not. First off, I’d like to state that while those rates are the cheapest on the market, many others such as Vanguard are awfully close and offer several ETF’s at less than 0.10% per year. Schwabb did take it one step further than anyone else had done in an attempt to gain market share.

How Is It Even Possible To Offer Such Rates?

I was asked by a good friend of mine how it was even possible to offer such rates. Are they losing money? Let’s take what I know to be an extreme example:

SPY is the largest US ETF and charges 0.095% per year. With its current assets of $120B or so, that amounts to about:

$114,000,000

Yes, you read that right. They then need some staff to do marketing, accounting, trades, etc. Let me tell you, it is a hugely profitable fund. In fact, it could be many many times smaller and still be worth it. If you’re trying to understand, just think about the following:

How many mutual funds have a fund that more or less tracks the S&P500? Start by thinking about banks, brokers, insurance companies and all of those other ones that all have their own fund. You’d get to thousands of different ones. Then, take those funds and start moving them into a couple of dozen (maybe a bit more) huge ETF’s. You will see how the economies of scale become very important. That is also why the only thing keeping the mutual fund industry alive is the fact that most investors don’t know how much they’re paying for them or can’t/won’t look for better alternatives.

I’m not sure if it can get much lower but I would argue that fees will continue to decline in the ETF space as was the case for trading commissions in the past decade. It won’t get to 0% but we’re getting closer and closer aren’t we?

With all of that in mind, which smart investor would ever pay 2-3% again for a standard passive fund?


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