THE PER­ILS OF ZERO-COST IN­VEST­ING

▶ Peo­ple who are happy pay­ing lit­tle or noth­ing in fees and com­mis­sions should be wary of the down­sides

The National - News - - BUSINESS MONEY -

If some­thing sounds too good to be true, it prob­a­bly is. There is a dark side to the wave of cost cut­ting that has swept through the ex­change-traded fund in­dus­try over the past year. While ev­ery av­er­age Joe in Amer­ica can now pay noth­ing to buy an ETF through their favourite bro­ker, and an ex­tra noth­ing to cover its an­nual man­age­ment fee, con­cern is mount­ing that there are catches to this bar­gain that could sur­prise in­vestors.

Bro­ker­ages have been fairly up­front about com­pen­sat­ing for their lost com­mis­sions with in­ter­est rev­enue, but man­ag­ing a fund – even one that tracks an in­dex – is not free ei­ther. It costs about $250,000 (Dh918,225) per year to run an ETF, with the ex­act amount depend­ing on what the fund owns, which ser­vice providers it hires and the is­suer’s broader busi­ness. But one way or an­other, whether it is le­gal costs, ag­gres­sive up­selling or ex­tra risk-tak­ing, in­vestors could wind up pay­ing.

“This isn’t Unicef, there is a cost as­so­ci­ated with do­ing things,” says Matt Bar­tolini, head of SPDR Amer­i­cas Re­search at State Street Global Ad­vi­sors. “My first ques­tion is how are these costs be­ing cov­ered?”

The an­swer? It de­pends. A fund’s man­age­ment fee typ­i­cally cov­ers the cost of li­cens­ing or cre­at­ing an in­dex, ad­min such as record keep­ing and prospec­tus mail­ings, as well as the ex­penses as­so­ci­ated with run­ning a board of direc­tors.

Is­suers that of­fer prod­ucts for free still have these costs, but they have more rea­son to try to re­duce them.

One place where ef­fi­cien­cies could be made is in the le­gal depart­ment, which could hurt in­vestors in the event of a law­suit. Other sav­ings could be made by con­struct­ing in­dexes in-house or li­cens­ing lower-cost al­ter­na­tives, hir­ing sec­ond-tier cus­to­di­ans, or lim­it­ing any sales pres­ence or ad­ver­tis­ing bud­get. These economies could re­sult in dam­ag­ing over­sights or in­crease the like­li­hood of the fund clos­ing.

“I would be con­cerned about the com­pli­ance and le­gal as­pect,” says Sam Huszczo, the founder of SGH Wealth Man­age­ment, a $170 mil­lion in­vest­ment ad­viser in Detroit that uses ETFs.

“Those are the two ar­eas where I could see cor­ners be­ing cut.”

Salt Fi­nan­cial, which pays in­vestors to buy its fund, keeps over­heads low by only swap­ping out two or three names per quar­ter, which low­ers trans­ac­tion costs, ac­cord­ing to co-founder Al­fred Eskan­dar. In Oc­to­ber, the com­pany said it planned to move the ETF to a trust main­tained by US Bank to re­duce ad­min­is­tra­tive and op­er­a­tional com­plex­ity.

The change will also save money, al­though Mr Eskan­dar says in­vestors will not be ex­posed to ad­di­tional risks. He hopes the lack of fees will en­cour­age in­vestors to try the fund, and that they will stick around due to its per­for­mance.

An al­ter­na­tive strat­egy for is­suers with more than one prod­uct is to lever­age their zero-fee prod­ucts to gen­er­ate other busi­ness. Fidelity In­vest­ments started the first zero-fee mu­tual funds in Au­gust 2018, but they are only avail­able to in­vestors that have a bro­ker­age ac­count with the com­pany. Mean­while, So­cial Fi­nance, an on­line len­der best known for re­fi­nanc­ing stu­dent loans, views its no-fee prod­ucts as a way to de­velop ex­ist­ing clients. Two of its ETFs cost noth­ing un­til at least June of next year, but an­other fund costs $5.90 for ev­ery $1,000 in­vested, more than the me­dian ETF fee.

The think­ing was “we will pro­vide this for free so you can find out all the other things avail­able in this com­mu­nity”, says Michael Venuto, chief in­vest­ment of­fi­cer of Toroso In­vest­ments, which helped SoFi start its funds. “It’s about en­gage­ment,” he says, adding that sell­ing more ex­pen­sive prod­ucts along­side zero-fee ETFs is not ne­far­i­ous.

A greater risk looms as these funds grow. ETFs ha­bit­u­ally lend out a pro­por­tion of their hold­ings to hedge funds and other bor­row­ers for a fee, part of which goes to in­vestors.

While the amount of se­cu­ri­ties that can be out on loan at any given time is capped by the reg­u­la­tors, is­suers of zero-fee funds could be in­cen­tivised to lend out a larger por­tion and keep a larger per­cent­age of the prof­its.

While no zero-fee ETF cur­rently en­gages in the prac­tice,

Fidelity’s four in­dex funds are el­i­gi­ble for se­cu­ri­ties lend­ing, ac­cord­ing to a com­pany spokesman. But all rev­enue – mi­nus lend­ing agent and cus­to­dial fees – goes back to in­vestors. ETFs need about $50m to make se­cu­ri­ties lend­ing worth­while, ac­cord­ing to Toroso’s Venuto, who says it is low risk.

Still, the race to zero shows no sign of let­ting up. Abol­ish­ing fees gen­er­ates pub­lic­ity, some­thing that could make the dif­fer­ence be­tween survival and liq­ui­da­tion in a mar­ket­place with more than 2,000 op­tions.

More than 70 per cent of US ETF as­sets are in funds that charge $2 per $1,000 in­vested or less and 93 per cent of new money has flowed into such prod­ucts this year, ac­cord­ing to data com­piled by Bloomberg.

Van­guard Group cut its fees again on Oc­to­ber 23, this time an­nounc­ing that it would re­duce the cost of 13 London-listed ETFs.

Mean­while, in the US, BNY Mel­lon has filed for a group of broad-in­dexed ETFs, fu­elling spec­u­la­tion that these prod­ucts could aug­ment the grow­ing pool of zero, or near-zero, fee in­vest­ments.

“If they’re not get­ting paid by the clients, how are they get­ting paid?” Dan Egan, man­ag­ing di­rec­tor of be­havioural fi­nance and in­vest­ing for Bet­ter­ment, says of zero-fee funds. “Peo­ple who are happy pay­ing noth­ing for some­thing are go­ing to get what they pay for.”

AP

Van­guard Group cut its fees again on Oc­to­ber 23, this time an­nounc­ing that it would re­duce the cost of 13 London-listed ETFs

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