ARE ZERO-FEE ETFs TOO GOOD TO BE TRUE?

▶ Smaller players charge next to nothing for their tracker funds but fail to win over investors, writes Harvey Jones

Exchange-traded funds have transformed investing by driving down fees to unimaginably low levels, allowing private investors to keep more of their returns for themselves, but has the revolution gone too far?

Top ETF providers Vanguard and BlackRock iShares cut fees on their most popular funds to an incredibly low 0.03 per cent a year, but now some smaller players have taken things a degree further.

They have launched ETFs with expense ratios that add up to the grand total of zero. That’s right, zilch. Nothing. Nada.

Last year, online lending platform SoFi launched two index ETFs that waived all management fees, and BNY Mellon Investment Management followed suit with two zero-fee funds, BNY Mellon US Large Cap Core Equity ETF and BNY Mellon Core Bond ETF.

New York boutique Salt Financial took the concept even further with its Salt Low truBeta US Market ETF, by granting a $5 rebate for every $10,000 (Dh36,725) invested. This meant it was effectively paying investors to take out the fund.

The idea that fund managers can charge zero or negative fees will astonish those accustomed to buying traditional, actively managed mutual funds. These are renowned for piling on the charges, with upfront initial fees of 5 per cent or 6 per cent and an annual charge of 1.5 per cent.

So, have investors responded by gratefully snapping up these zero-fee ETFs to save themselves yet more money?

Perhaps surprisingly, they haven’t. Salt Financial attracted just $9 million from investors in its first year and withdrew its offer. The fund was snapped up by a rival, which will charge a fee of 0.6 per cent.

SoFi and BNY Mellon’s zero-fee ETFs garnered just $37m between them in the past three months, according to research company CFRA. It seems you really can have too much of a good thing.

Stuart Ritchie, director of wealth advice at AES International, says investors rightly love the low charges on ETFs.

“Funds charging less than 0.10 per cent a year tend to attract higher inflows than more expensive counterparts.”

The problem is that zero-fee ETFs just did not ring true. SoFi’s zero-fee offer lasted only for the first year, while the rebate on Salt Financial’s Salt Low truBeta US Market ETF was only applicable during the first year or until it reached $100m in assets (a target never achieved) as it looked to build scale up. Zero-fee offerings looked like a marketing gimmick, Mr Ritchie says.

“Investors are smart and recognise these sales tactics.”

Investors also prefer to stick to established brands they know and trust, which is understandable when investing large sums, Mr Ritchie says.

“Price is just one consideration. Financial strength and reputation are important, too. Clients want to know their money is safe and feel better with a familiar name.”

ETFs have been a huge success since the first one was launched in 1993. At the end of last year, assets stood at $6.35 trillion, according to ETFGI, a research and consulting company. Bank of America predicted the total could hit a mind-boggling $50tn by 2030.

This success is to be applauded and low fees are at the heart of it. Before ETFs came along, many investors were resigned to paying high fees to active fund managers and financial advisers, and this had a draining effect on performance.

Let us say you invested $100,000 in a fund charging 1.5 per cent, then another $100,000 in a fund charging 0.10 per cent. Then let us assume both grow at exactly the same average rate of 6 per cent a year.

After 30 years, the more expensive fund would give you $374,532. That sounds impressive, until you see what you would have with the cheaper fund. That would give you $558,314, which is an incredible $183,782 more.

The difference is purely due to the size of the annual fee. That 1.5 per cent charge inflicts outsize damage when you pay it year after year. So, hooray for low-cost ETFs.

Vijay Valecha, chief investment officer at Century Financial, says the war on low fees has already been won and conclusively.

“While a free ETF can be eye-catching, investors remain loyal to broadly diversified and extremely low-cost offerings from leading names such as iShares, Vanguard and Charles Schwab.”

The competition is cutthroat among the big names. In March last year, the hugely popular Vanguard S&P 500 ETF cut its fee to 0.03 per cent. This forced BlackRock to respond, recently cutting the 0.04 per cent fee on iShares Core S&P 500 ETF to match.

Mr Valecha says with expense ratios this low, investors see little benefit in swapping to a cheaper alternative offered by lesser-known providers.

The challenge ETF providers face is to provide better-performing products, he says. What sits inside a fund now matters more than the total expense ratio, Mr Valecha says.

ETF managers have different ways of tracking their chosen index. Some buy the physical asset in question, others use complex financial instruments to replicate performance, but these ultimately may not be as accurate.

“Sofi Select 500 ETF tracks the broad S&P 500 Index but is weighted based on three fundamental growth factors and actually tracks a lesser known proprietary index. Likewise, BNY Mellon Core Bond ETF tracks [the] third-party Bloomberg Barclays US Aggregate Total Return Index,” Mr Valecha says.

One brand that has done well out of zero-fee ETFs is global investment manager Fidelity. It offers four “zero-expense ratio index mutual funds” through its retail brokerage accounts and goes a step further by also waiving account fees.

Mr Valecha says its strategy has paid off.

“Fidelity Zero Total Market

Index Fund gathered more than $1.4bn in its first three months, thanks to its strong brand and the fact it exclusively sells its funds to investors on its brokerage account.”

However, Emiratis and non-Emiratis should approach with caution. These funds are domiciled in the US and should be avoided by anybody who wants to sidestep a brush with the country’s Internal Revenue Service.

Elie Irani, board member of SimplyFI, a non-profit community of UAE investment enthusiasts, says this is the main reason that put him off zero-fee ETFs.

“They are all US-domiciled and hence expose the non-American investor to the US Estate Tax trap, which charges a punishing 40 per cent on all assets exceeding $60,000.”

Mr Irani prefers to stick to established providers such as Vanguard, iShares and State Street Global Advisers’ SPDR range, which are available in non-US domiciled versions.

Mark Chahwan, co-founder and chief executive of Dubai robo-adviser Sarwa, which offers investors balanced portfolios of low-cost ETF portfolios, says zero-fee ETFs will only grow in popularity if Blackrock, Vanguard and State Street begin to offer them.

He says investors are smart and not chasing low fees for the sake of it. They are not willing to compromise on the name of the provider.

“Low fees are the way to go but not at the expense of performance. It has to be a balance.”

ETF fees are important, but they are not everything, Mr Chahwan says.

“An ETF is more than just a low-cost investing tool. Selecting the right one is about finding a product that is built to increase performance while lowering risk.”

For now, the Sarwa site focuses on offering diversified ETFs from the two big established names, Vanguard and BlackRock.

The truth is that the low-cost ETF revolution has been fought and won. Private investors are the beneficiaries and can afford to relax. Even if you hate paying charges, it is hard to complain about 0.03 per cent a year.

Price is one consideration. Financial strength and reputation are important, too. Clients want to know their money is safe