The race for lower fees shines a light on smart beta

Hybrid strategy between active management and index funds needs to perform and be cheap

Oct 6, 2016 @ 1:30 pm

By Jeff Benjamin

As BlackRock Inc. throws down the gauntlet with some sweeping price cuts across its exchange-traded funds lineup, it's only logical to assume the increasingly popular smart beta strategies will be next in line to feel the spreading pressure on fees.

Smart beta, which is also known as strategic beta and fundamental indexing among a host of other names, has been carving out a comfortable wedge between traditional indexed investing and the kind of actively managed strategies more popular with mutual funds.

But, just as BlackRock's announced fee cuts were pegged to the Department of Labor's looming fiduciary rule for retirement advice, smart beta is being pulled into the conversation.

“Fee compression is happening across the asset management industry,” said Ed Egilinsky, managing director of alternatives at Direxion Investments, which manages $11 billion across 50 ETFs, including five smart beta strategies.

The U.S. strategic beta strategies tracked by Morningstar have an average expense ratio of 48.5 basis points, which is bargain-basement territory compared to the 1.206% average expense ratio for U.S. equity open-end mutual funds.

But, as is typically the case, averages can be deceiving.

Dividing the mutual funds by share class shows an average institutional-share expense ratio of 0.907%, while C-shares top the charts with an average 1.971%.

Among smart beta ETFs, according to Goldman Sachs, U.S. equity ETF fees can be as high at 1.38%.

Mr. Egilinsky, whose smart beta strategy fees range between 35 and 65 basis points, believes the pressure will first hit actively managed mutual funds as they try to compete with smart beta.

But though the fees for smart beta, representing the hybrid between active management and indexed investing, will look good next to active management, they will also be challenged to compete with the cheaper indexed strategies.

“A lot of the fee compression in the ETF space has been in the cheap beta space,” Mr. Egilinsky said. “When you look at the smart beta space, I think it's more of a threat to the active management space, which is where I think you'll see the fee compression.”

However, he admits to be paying attention to patterns emerging, including the one-year-old Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) , which charges just 9 basis points.

Todd Rosenbluth, director of mutual fund and ETF research at S&P Global Market Intelligence, said fees are coming under pressure across the board in the asset management industry, and smart beta is not likely to survive the trend unscathed.

However, he added, there is a case for smart beta strategies charging more than traditional indexed products.

“Smart beta fees tend to be a little higher than a fund that just tracks a market-cap weighted index, and investors appear to be willing to pay more for something that adds value,” Mr. Rosenbluth said.

As the DOL fiduciary rule drives more financial advisers toward an increased focus on fees, Mr. Rosenbluth believes the ETF providers will continue to view lower fees as a form of a competitive edge.

“BlackRock has made it quite clear they are prepared to be aggressive in pricing their products,” he said. “This latest move appears to be clearly focused on trying to be price competitive with Vanguard, the number two ETF provider.”

This year through September, BlackRock had $939 billion in ETF assets, followed by The Vanguard Group at $576 billion.

But Vanguard has captured a slight edge in inflows, attracting $63.3 billion worth of new money over the first nine months of the year, compared to $62.8 billion for BlackRock.

Ultimately, fees matter, and will likely play an even bigger role as the DOL rule unfolds in April. But, as Mr. Egilinsky put it, performance will not be completely overlooked.

“Fees only matter if the strategy is not working,” he said. “People will not mind paying 65 basis points if the strategy works and meets its objective and can beat its bench mark.”

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