The Race to Zero in Index Funds
Investors are paying less than ever before to own U.S. open-end mutual funds and exchange-traded funds (ETFs). The intensifying competition among asset managers and the increasing usage of passively managed investment strategies are contributing factors. In fact, passively managed funds recently surpassed those that actively manged for the first time. The rush to adopt lower cost funds has been one of the dominant investment themes of the decade, driven by investors’ new-found love for inexpensive passive investing in the aftermath of the financial crisis.
Source: 2019: Investment Company Fact Book
While the average expense ratio for all funds has decreased in recent years, the average cost of index mutual funds and ETFs has fallen more than the average of actively managed funds. When looking at the least expensive passive funds, the impact of the price war between the low-cost providers is evident. For example, U.S. investors can have passively managed exposure to track the S&P 500 at 1.5 basis points, which translates to paying $0.015 per $100 invested in the portfolio. As low-cost providers continue to cut their fees, questions are being raised: How long can investment managers sustain nearly-zero expense ratios and remain profitable? At what point in the future will asset managers pay investors to manage money?
Source: 2019: Investment Company Fact Book
Passive Versus Active
Passive (index) funds aim to replicate the benchmark which they track. Portfolio managers have no discretion on the portfolio position, and therefore the funds tend to have lower expense ratios than their active counterparts. Active managers have a goal of outperforming their respective benchmark. They do so by constructing a portfolio using companies included in the benchmark, and some that are not. There are several reasons why the expense ratios for actively managed funds are higher than that of their passive counterparts, with the primary being that analysts and portfolio managers spend a significant amount of time researching the companies included in the portfolio. Active managers, supported by team of analysts, conduct additional research and due diligence on the companies’ stocks and/or bonds to gain an informational advantage in an effort to outperform the index.
Index funds replicate the market indices and hold the securities until the firm responsible for constructing the index makes changes to the composition. Therefore, passively managed funds do not require additional expenses for research and due diligence. Additionally, many index funds can lend their securities as collateral for short positions. The fund receives a stock loan rebate, in the form of a payment from the lender to the borrower.
Source: 2019: Investment Company Fact Book
Investors are increasingly aware of the importance of minimizing investment costs, which has led them to favor lower-cost funds. The higher expense ratio of an actively managed fund lowers the return of the investment; therefore, portfolio managers look to achieve alpha (i.e., additional return above the benchmark) to compensate for the additional expense. Actively managed funds with higher fees have a bigger hurdle to overcome in order outperform their benchmarks. Also, in certain asset classes, some average managers have continued to underperform their benchmarks (1).
Certain asset classes tend to be quite efficient and thus, it is difficult for the manager to consistently achieve alpha. Greater awareness by investors of this phenomena, and of fees in general, have shown the advantages of passive investing in certain asset classes and has led to massive inflows in passively managed funds.
How Can Passively Managed Funds Have Zero Fees?
In order to gain market share and increase assets under management of passively managed funds, some index fund providers have engaged in a “fee war,” consistently undercutting the expense ratios and eliminating the investment minimums of their funds. This leaves investors wondering how the funds can have such low fees - with some close to zero - and how this “race to zero” is sustainable. Some of the factors that help to continue to cut fees include:
The increased usage of advanced technology allows the larger index providers to better track the index (e.g., the optimization of trading costs translates to a more similar performance to the benchmark which they are tracking).
Securities lending is a widely used investment strategy involving the loan of portfolio securities to financial institutions that have a need to borrow. Income from securities lending is generated by the fees paid from financial institutions for lending securities and the return on collateral (which must be a minimum of 100% of the position size). Asset managers receive cash or acceptable collateral to protect themselves from the borrower failing to return the securities. When cash collateral is delivered, the lender (i.e., a passively managed fund) invests it during the term of the loan and retains any return on the investment (less any rebate paid to the borrow). While this is a basic concept, index fund providers have different approaches and processes when investing the collateral.
These differences can include the utilization rate of loaned assets (the SEC limitation on the percentage of total assets that can be loaned out is 33%) and the investment strategy for investing the cash collateral. Therefore, when selecting passively managed funds, it is important to review their securities lending policies and ensure any generated income is returned to investors and not managers. If income is returned to managers, the fund fees do not reflect the “real” expense ratio of the fund.
Small-cap index funds earn more in security lending than their larger-cap counterparts, as they hold securities that are in high demand and not readily available. For example, Vanguard earned 0.14% in income on the Vanguard Russell 2000 Growth Fund’s assets in 2018 by lending out only 1.48% of the small-cap growth index fund portfolio. In this example, the income went back to the fund’s performance, however, not all index providers employ the same process (2). While 1.48% is minimal, other index providers have more flexibility in the percentage of total assets used for securities lending and can go up to 30% (3).
While securities lending can provide an opportunity to increase portfolio returns, it can also increase risk. Two of the major risks are counterparty risk and collateral reinvestment risk. Counterparty risk is the concern that the borrower of a security could default on its obligation to return the securities, which would result in losses to the relevant index fund. Investment risk refers to the potential loss of principal due to the exposure the of cash collateral that is reinvested. As mentioned previously, some index providers take a more aggressive strategy in reinvesting the cash collateral, and this led to losses for some funds in the 2008 financial crisis (4).
The increasing market share for index providers translates to economies of scale benefits and a marginal cost of running the fund. Increasing scale allows index fund providers to lower their trading costs, and therefore increase managers’ ability to more closely replicate benchmarks. Also, as assets under management increase, managers can cut their fees more aggressively without affecting fees stated in dollars, as larger assets typically have their expense ratios stated as percentages.
Evaluating Passive Investments
Over the last few years, index fund expense ratios have compressed meaningfully across the industry. As a result, fee differences have become a nearly immaterial differentiator. When selecting a passively managed index fund, fiduciaries must look beyond expense ratios, and at a broader set of more complex factors. The chart below highlights some of these:
A conservative, well-managed securities lending policy can have potential benefits in an index fund, as income generated can enhance the portfolio’s return and allow the passively managed fund to cut fees, therefore reducing their tracking error relative to the index they are tracking. However, the increased adoption of securities lending and aggressive collateral reinvestment strategies create divergences among the index and index funds, therefore increasing tracking error.
Given that the demand for lower-cost funds continues, this space has, and will continue to see, mounting fee pressure in the coming years. With the ongoing squeeze in fund expenses, it is likely that securities lending will continue to rise.
(1) Morningstar: U.S. Active/Passive Barometer: 7 Takeaways from the Midyear 2019 Report
(2) Vanguard Equity Index Fund Quarterly Review 06.20.2019
(3) Morningstar: Securities Lending An Examination of the Risks and Rewards
(4) Federal Reserve Bank of New York: Securities Loans Collateralized by Cash: Reinvestment Risk, Run Risk, and Incentive Issues
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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