ETF Fees Keep Falling

When Vanguard arrived in Canada last year, a number of my readers suggested the competition would prompt other ETF providers to lower their management fees. I was skeptical: after all, competition in the ETF space was not new, and with the exception of Vanguard itself, no provider in Canada or the US had ever shown a willingness to reduce fees in the past. Well, I’m happy to report I was wrong.

This week BMO announced it will be slashing the fees on two of its ETFs, effective November 1. First, the BMO S&P 500 (ZUE), which changed its benchmark index last month, will be dropping its fee from 0.22% to 0.15%. It’s not a coincidence that the new MER is identical to what Vanguard has announced for its own S&P 500 ETF, set to launch later this year. Both the BMO and Vanguard funds will now be significantly cheaper than the category leader, the iShares S&P 500 (XSP), which charges 0.24% on its $1.58 billion in assets.

In addition, the BMO Aggregate Bond (ZAG) will lower its fee from 0.28% to 0.20%. Again, that puts the cost in line with Vanguard’s broad-market bond fund, and it undercuts the giant iShares DEX Universe Bond (XBB), which sports a management fee of 0.30% and holds almost $2 billion.

The BMO news comes on the heels of an October 1 announcement that Horizons was rebating part of the fee on its Horizons S&P/TSX 60 (HXT), which just celebrated its second anniversary. Already one of the cheapest ETFs in the country, HXT will rebate two basis points of its management fee, lowering its annual cost to 0.05% for at least the next 12 months. This fund’s tracking error is already close to zero, which means it’s now possible to capture the returns of Canadian large-cap stocks at a trivial cost.

iShares feels the pressure

The ETF price war has been raging south of the border, where Schwab recently slashed the fees on its ETFs to as low as 0.04%. This trend has not been lost on BlackRock: they have indicated they will reduce fees on some iShares ETFs in the US, probably before the year is out. So far BlackRock Canada has been silent about whether it will follow suit, but they may have little choice if they want to retain their dominating market share.

According to the Canadian ETF Association, iShares and Claymore together made up almost 83% of ETF assets in December 2011. BlackRock acquired Claymore earlier this year, but as of September 2012, their total market share had slipped to 76.5%. Meanwhile, BMO’s rose from 8.9% to 14% during the same period. (Vanguard so far controls just 0.6% of Canadian ETF assets, but that will certainly grow significantly.)

The casualties of a price war

While cost-conscious investors tend to get giddy over price reductions, it’s important not to get carried away. I worry about the temptation to hop from one ETF to another in pursuit of a few basis points of savings. Indeed, I regularly get e-mails asking me when I will be swapping the ETFs in my model portfolios with lower-cost funds, often within a few days of the announcements. I will no doubt make changes in the future, but I’ll only add a new ETF after it has a track record of at least one year. Remember, the true cost of an index ETF is reflected in its tracking error, not its management fee. It is quite possible for an ETF with a lower fee to post a higher tracking error than a more efficient competitor.

More importantly, while fees are a crucial factor in investing, there is a danger of engaging in a race to the bottom. I’m a bit concerned about how ETF providers might respond to brutal competition. If they’re forced to operate with razor-thin margins, perhaps they’ll be tempted to engage in more extracurricular activities, such as securities lending. Already we’re seeing a move toward fewer third-party indexes, which may cost a few basis points in licensing fees but also offer an extra layer of accountability that investors should welcome. Lower fees are a wonderful thing, but not if they come at the expense of prudent fund management.

17 Responses to ETF Fees Keep Falling

  1. Michael James October 12, 2012 at 10:42 am #

    I take the risk-averse view that securities-lending revenues are offset by costs of administering securities lending and the added risk of loss by ETF unit-holders due to default on lent out shares. It may be the case that there is genuine profit here, but someone would have to prove this to me. Taking this view, any securities-lending revenue kept by the ETF provider is coming out of my pocket in the form of actual cash or added risk of loss (i.e., probabilistic cash). So, to get a proper handle on costs, I would add the MER and any securities-lending revenue kept by the ETF provider. Another consequence of taking this view is that tracking error doesn’t quite tell the whole story; you have to subtract the added risk from the possibility of a default on lent out shares.

  2. Canadian Couch Potato October 12, 2012 at 11:05 am #

    @Mike: My feeling is that securities lending is very low risk when it’s done prudently, and from what I have been able to determine ETFs in Canada don’t do very much of it. You might argue that if they didn’t do it they would be compelled to charge higher fees, since the margins are already pretty slim on the smaller ETFs. But I definitely agree it’s a practice one needs to pay attention to.

  3. Onkar October 12, 2012 at 2:24 pm #

    Very timely article. I am debating to switch to BMO Aggregate Bond (ZAG) considering that fee is good 10 bps lower than iShares XBB. The problem I see is that it lagged by almost 0.5% in performance(with DRIP) since inception compared to XBB which would imply that the Tracking errors for ZAG are bit higher than XBB. The other issue is that ZAG tracks different index(DEX UniverseXM Bond Index ) for which I have not been able to find any information.

    I am also considering HXT in my non registered account. I have started to build position in XIU recently but its not that much yet. The reason I am considering HXT in non-reg is mainly for tax purposes since HXT does not have any dividends and essentially tracking error is close to zero plus lower fee is an added bonus. I am aware of swap and risk associated with that. Horizon used to mention that there is swap fee that is waived for certain period, I don’t see it being mentioned anymore.

    insight on both of these would be welcomed.
    Thanks

  4. Canadian Couch Potato October 12, 2012 at 2:52 pm #

    @Onkar: According the BMO and iShares websites, the most recent one-year performance (period ending September 30) for ZAG was 5.48%, compared with 5.15% for XBB. Year-to-date performance is virtually identical.

    The “XM” in ZAG’s index stands for “except municipals.” Given that municipal bonds make up less than 1.5% of the DEX Universe, I expect this difference would be trivial. I’m speculating here, but my guess is that BMO could not (or chose not) to license the same index as one of their competitors, so they commissioned one that was superficially different, but substantially the same.

    As for HXT, there is no fee for the swap. If there were, it would show up in the tracking error. (Note there is a 40 bps fee for the swap in HXS.)

  5. gsp October 12, 2012 at 9:07 pm #

    Just checked since I own some, HXS swap fee is still listed at 30bps in the latest prospectus.

  6. BC_Doc October 13, 2012 at 2:53 pm #

    I’m hoping the downward pressure on MERs will continue as I consider many of the Canadian ETF costs still too high. Specifically, the bond ETF costs are too high in my opinion– VAB clocks in at a 0.20% MER plus taxes versus 0.10% MER for BND which would be its Vanguard equivalent on the U.S. side. Similarly VSB has a 0.15% MER as compared to its US “cousin” BSV with a 0.11% MER. I don’t follow the Canadian equity products all that closely as all my equity ETFs are invested with US Vanguard products (VEU and VTI). As a guy that learned from Jack Bogle that costs matter, I’m waiting for Vanguard Canada to lower its bond ETF costs before I wade in! Currently, my fixed income investments are in laddered GICs.

    Thanks for another great article!

    Regards,

    BC_Doc

  7. Canadian Couch Potato October 13, 2012 at 3:11 pm #

    @BC_Doc: Let’s remember that Vanguard’s US index funds have not always been as cheap as they are now. On the contrary, they used to be considerably more expensive than Canadian ETFs are today. Only after they gathered a lot of assets have the crept down in price. BND currently has $114 billion in assets, which is roughly 2.3 times the size of the entire Canadian ETF industry.

    BMO has taken the lead in the price reductions in Canada, and kudos to them, but they have now been gathering assets for more than three years and they are up to $7 billion now. Vanguard Canada still has a ways to go.

  8. Smoothmoose October 17, 2012 at 12:58 pm #

    Does anybody have recommendations on Canadian based investment newsletters that have a strong focus on Index Funds and ETFs? I’ve searched high and low and have followed the Hulbert Digest for years and have on and off subscribed to No Load Fund X, several US ETF newsletters, and the Canadian based Investment Reporter (focused on equities).

    I guess I want to be an more active couch potato investor and gain further insights on the tracking and fundamentals of the every increasing universe of Canadian ETF offerings.

  9. Trevor C January 3, 2013 at 8:52 pm #

    Here’s something weird. Why is it that when I search for HXT on through Royal Direct, what I get is the Horizons BetaPro S&P/TSX 60 Index ETF? Aren’t the BetaPro ETFs leveraged? That’s not what I want. (To say nothing of the fact that the fee shows as 0.08%, not 0.05%) Why can’t I seem to find the regular swap ETF that you’ve written about frequently. And why does the BetaPro designation never show up on the Horizon’s site when I search for HXT?

    Is it possible that Royal Direct only offers leveraged versions of the Horizon’s ETF’s? Seems very strange.

  10. Canadian Couch Potato January 3, 2013 at 9:57 pm #

    @Trevor: As long as you enter the correct ticker symbol, you’re fine. It sounds like RBC has simply entered the wrong name for HXT. There are are leveraged BetaPro S&P/TSX 60 ETFs from Horizons: the tickers are HXU and HXD. Just make sure you don’t enter one of these by mistake. If in doubt, you can always call customer service to double-check before you place your order.

  11. Trevor C January 4, 2013 at 11:02 am #

    Thanks, Dan. Just as a follow-up, I called both Royal Direct and Horizons this morning and you’re right, there seems to be some naming confusion at Royal Bank. Apparently Horizons changed the name at some point, and Royal Direct never caught on to that. The person at Horizons that I talked to described himself as “very surprised” that Royal Direct hadn’t registered the name change.

    To me it just adds a whole extra layer of uncertainty around dealing with Horizons securities, which maybe is unfair to them. But when investors, like me, are already dealing with a degree of concern around non-traditional swap products, and then encounter a mistake like this — so that you can’t be sure what you’re buying, and it might be a LEVERAGED product — it makes the whole thing seem a lot dicier.

  12. Canadian Couch Potato January 4, 2013 at 11:16 am #

    @Trevor: Glad you got this sorted out. I don’t think one can fault Horizons here—definitely sounds like an RBC problem.

  13. Willy March 11, 2014 at 11:10 am #

    I notice ZAG has a listed expense ratio of 0.200%. Yet if you look at its holdings, ZAG is comprised of several other BMO bond ETS with MERs ranging from 0.200% to 0.300%. Does the MER of ZAG include the MER of the underlying funds? Or is it layered on top (so you are really paying 0.2% + 0.2-0.3%)?

  14. Canadian Couch Potato March 11, 2014 at 11:17 am #

    @Willy: When an ETF is made up of other ETFs from the same provider (which is common at BMO), there is no double-dipping on fees.
    http://www.theglobeandmail.com/globe-investor/investment-ideas/is-my-etf-double-dipping-on-fund-fees/article4182696/

  15. Willy March 11, 2014 at 11:48 am #

    Thanks for the quick response. Is this by industry convention, or by legislation/rule, or…?

  16. Canadian Couch Potato March 11, 2014 at 1:08 pm #

    @Willy: I’m not sure whether double-dipping is specifically prevented, but the fund would need to disclose the arrangement. The proof would be in the tracking error anyway: if there were two levels of fees, the tracking error would be huge.

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