Zero-Cost ETFs: At What Price?

by Will Ashworth | April 8, 2013 12:40 pm

I’m pretty sure the average investor who owns one or more exchange-traded funds in his or her IRA couldn’t explain how they work. When caught off guard with my thoughts elsewhere, I too sometimes have difficulty with the whole process — and I write about investments on a daily basis!

So, when I read that Vanguard‘s head of investments in Europe suggested that ETF fees could go to zero[1] thanks to securities lending activities by the ETF providers, I immediately thought about average investors. It’s already difficult to make an investment decision when you barely understand how the darn thing works — and now you have to factor in the securities lending practices of your ETF? It’s enough to make your head spin.

But forgetting all the mumbo jumbo, what does this mean for you — John Q. Public?

The idea of eliminating management expense fees sounds very enticing. Zero-commission ETFs already exist, so zero expense ratios would seem to be a natural extension of that.

Except for one thing: Free is never free. There’s always a catch. When in your lifetime have you gotten something for nothing? Zero percent financing is a perfect example. You might think you’re getting a deal, but what you gain in interest you lose in rebate dollars. In the end, you generally end up saving very little.

The same applies to ETFs.

Vanguard is a unique example given its ownership structure (it operates much like a mutual insurance company where the insured own the company), but since it was a Vanguard executive who floated the idea, I’ll stick with it.

Let’s assume for a second that zero management fees apply to the Vanguard S&P 500 ETF (NYSE:VOO[2]). To keep things simple, let’s also assume that you have $10,000 invested in the fund. Currently, Vanguard charges an annual expense ratio of 0.05%. Vanguard’s prospectus estimates that your $10,000 would appreciate by 5% annually over the next 10 years and you would pay $64 in cumulative fees. The elimination of those fees means you’re saving $64, or less than $7 per year.

Because of its ownership structure, Vanguard operates its funds at cost, which explains its low-cost leadership position. For comparison’s sake, State Street‘s (NYSE:STT[3]) charges 0.09% annually for its SPDR S&P 500 ETF (NYSE:SPY[4]), and assuming it operates with a similar cost structure as Vanguard, it’s taking 44% of its fee in profits while Vanguard is simply covering its overhead.

Under this zero-fee assumption, Vanguard must come up with $64 million in annual revenue from somewhere else to keep the fund running. That “somewhere else” is from fees received for lending out the securities that make up the fund’s $128.7 billion in total net assets. According to regulations, Vanguard can lend out up to one-third of its assets, or $43 billion.

Industry data suggests the average return for ETFs is 0.06% when lending securities. Therefore, under current rules, the maximum revenue VOO would likely generate from lending securities is $25.8 million — far short of the required amount to keep the fund running.

If it’s this bad for Vanguard, imagine what it would be like for other fund companies that operate for-profit organizations to try to drop expenses to zero.

Bottom Line

BlackRock (NYSE:BLK[5]) is currently involved in a lawsuit with two pension funds who assert that the iShares provider isn’t returning to shareholders enough of the profits from its securities lending activities. The company admits it takes about one-third of the profits, with the rest going to investors.

Obviously, any money made by Vanguard from this type of activity goes right back into the funds. But do we really want to spend our time searching through ETF financial statements to find out who is making what? There is little evidence that I can find that shows investors are making any real money off this exercise. Someone’s getting rich, but it isn’t you.

As I said in the opening, the average investor likely can’t explain how an ETF is constructed. Therefore, it’s also likely that they won’t be able to determine whether securities lending is a good or bad thing for their portfolio. Nobody knew the risk of packaging up mortgages, and now look at the damage CMOs have caused in housing.

While synthetic ETFs exist to replicate industries and markets not easily done with equities, physical ETFs — the basic stock kinds you and I are most familiar with — were meant to invest in a “basket of stocks.” When securities lending is undertaken in any form, the physical ETF you have bought is no longer as advertised until all the shares lent out to others are returned to the fund.

Although the risk of securities lending for investors is limited, it does beg the question why you would invest in something that isn’t as it appears.

Especially when it’s clear there’s not much money in it for you.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

  1. ETF fees could go to zero:
  2. VOO:
  3. STT:
  4. SPY:
  5. BLK:

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