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.