‘Loss leaders’ boost returns for investors but come with new risks; gasps at Goldman Sachs

By Jason Zweig and Sarah Krouse
Published on Jan 26, 2016 on The Wall Street Journal

In November, asset manager BlackRock Inc. said it would slash by more than 50% the annual expenses charged to investors in an exchange-traded fund that aims to mimic the performance of the entire U.S. stock market.

By the end of the day, executives at rival Charles Schwab Corp. had matched the price cut. In December, Vanguard Group announced fee cuts of as much as 25% at dozens of its funds.

The cost of investing is tumbling toward zero for some basic portfolios of stocks and bonds as firms duel for customers. The slide has been under way for years but is accelerating as the industry’s biggest companies target increasingly cost-obsessed investors.

More than 100 mutual funds and exchange-traded funds now cost $10 or less per $10,000 invested, up from 40 in 2010, according to Morningstar Inc.

BlackRock’s move left its ETF with annual expenses of 0.03% and sharply reduced fees at six other funds. Schwab has responded with cuts nearly a dozen times in the past three years.

“That’s pretty much the first and only thing I look at: the expenses,” says Brolin Walters, a credit-risk analyst at a financial-services firm in Virginia who manages his own investments and recently put more money in BlackRock’s iShares Core S&P Total U.S. Stock Market ETF.

He pays 0.03%. “If you can do it cheaper than the next guy, then yours is the one I want,” says Mr. Walters.

Overall, the average fund tracked by Morningstar charges 1.07%, down from 1.22% in 2005. The steepest slide has been at passively managed mutual funds and ETFs that try to track broad indexes at a fraction of the cost of human money managers who handpick investments.

The consequences are more complicated than they might seem at first. While lower expenses leave people with more money to amass for retirement and other uses, nearly free funds are equivalent to the loss leaders sold by supermarkets as come-ons, some money managers and analysts say.

They say bargain-basement funds help get investors in the door, where they can be pitched pricier portfolios that often are riskier, too.

The strategy is “taste the honey and come in so we can show you all our other products,” says Rick Ferri, founder of Portfolio Solutions LLC, an independent financial-advisory firm in Troy, Mich.

Fund companies say the slide toward zero is a huge benefit for investors, many of whom can benefit from a combination of low-cost, plain-vanilla funds and more-complicated ones that offer exposure to niche markets.

But declining costs are pressuring the industry’s profit margin, which slipped to 22% in last year’s third quarter from 25% a year earlier, according to consulting firm DST Kasina, part of DST Systems Inc.

Fund expenses cover the sponsoring company’s costs of investment research, sales and marketing, and other services.

Eke out a profit

Only the largest asset managers have the operating efficiencies needed to eke out a profit on funds that charge 0.03% or less, so the pressure to get even bigger has become more intense than ever. Firms that use portfolio managers to choose stocks and bonds face an especially brutal squeeze.

Even though actively managed mutual funds did better overall last year than market-cloning competitors for the first time since 2012, clients pulled about $200 billion from actively managed stock and bond funds in 2015, according to Morningstar data. Passively run funds attracted roughly $400 billion.

Actively managed U.S. stock funds suffered their worst annual outflow ever. As costs keep declining, traditional money managers “aren’t going to be able to compete” unless they are able to outperform passive funds, says Mark Wiedman, global head of BlackRock’s iShares business.

The race to zero has been accelerated by several forces. The Federal Reserve’s low-interest-rate policy slashed the income on bonds and cash, making high fees stick out like sore thumbs, analysts say. Young investors are acutely focused on costs and skeptical of advice. And even older investors who were accustomed to putting money into traditional funds felt burned by devastating losses in 2008 and 2009.

Steve Deschenes, head of client analytics and research at the Capital Group Cos., says human stock and bond pickers suffered from an “asymmetry of blame” during the financial crisis. Capital Group is the parent of American Funds, where investors withdrew about $250 billion from 2008 to 2013. Its mutual funds have about $1.1 trillion in assets.

“If you held index funds, you said: ‘I held the market, so I expected to lose money in a decline,’ ” he says. “But if you held money in an active fund, you said: ‘My manager didn’t sidestep the decline.’ ”

Some money managers that get much of their revenue from actively managed funds are fighting back, partly by getting more vocal about the potential risks of index investing. They say the strategy forces investors into risky bonds or pricey stocks just because they are part of a benchmark.

AllianceBernstein LP has increased its marketing of actively managed strategies for assets such as high-yield bonds. The firm hasn’t cut its fees. “We’re not surprised at all to see passive managers compete on fees because that’s their only differentiator,” said Chris Thompson, AllianceBernstein’s head of distribution for the Americas.

For investors, small savings on fees can make a big difference in the long run.

Securities and Exchange Commission economist Timothy Riley calculated in a study released in September that investors could save $25 billion a year—or more than $200 per household in the U.S.—by switching from actively managed mutual funds to passive ones seeking to replicate an index like the Dow Jones Industrial Average, S&P 500 or Barclays Aggregate Bond Index.

A decade ago, a $10,000 investment in the average actively managed U.S. stock fund cost $97 a year. The stake would grow to $43,591 after 30 years, assuming an average annual return of 6% in the stock market. In the past decade, the stock market had a 7.3% average annual return.

The same $10,000 investment in a fund with annual costs of 0.03% would swell to $56,949 in 30 years.

Samuel Lee, founder of Severian Asset Management LLC, a financial-advisory firm in Chicago, says the biggest asset managers are trying to promote a few dirt-cheap ETFs that establish “a reputational halo of low cost.” Costs on other ETFs and mutual funds are being held steady or even climbing, say some industry analysts and executives.

Last year, fund firms launched 117 ETFs that cost more than 0.5% but only 21 with expenses of 0.1% or less, according to Morningstar.

ETF providers say higher-cost funds typically offer exposure to markets or strategies that are specialized, complex and otherwise would be even more expensive for individual investors.

Still, there is no doubt that dirt-cheap funds are sending shock waves through the financial industry. Some executives at Goldman Sachs Group Inc. gasped at a meeting last fall when the company’s asset-management unit introduced a new ETF with annual fees of just 0.09%, according to a person familiar with the matter.

The Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF relies on computer models to form a relatively static portfolio of stocks and is designed to beat the market by using such factors as “value,” or stocks trading at cheap prices, and high profitability.

The new fund aims for returns that beat the S&P 500. Its rock-bottom fees undercut one of the world’s largest ETFs, SPDR S&P 500 ETF Trust, which charges 0.0945% a year. That fund is managed by a unit of State Street Corp. State Street says it hasn’t changed the fund’s fees.

Goldman’s U.S. large-cap stock ETF also costs about one-fourth as much as some rival “smart beta” funds that hold broad baskets of assets selected by criteria other than market value alone, according to the firm. The ETF has attracted more than $250 million in assets so far.

Like many other investment firms, Goldman also is competing against itself. Its asset-management unit is best known for hands-on attention to pension funds, wealthy individuals and advisory firms that cater to rich investors.

“Clients have asked for this product and we are agnostic about whether its growth comes from new or existing clients,” a Goldman spokesman says.

Goldman’s launch “got a lot of their competitors fretting over the direction things are headed,” says Ben Johnson, director of global ETF research at Morningstar.

Marie Chandoha, chief executive of Schwab’s investment-management unit, says the company was late to the game when it launched its first ETF in 2009. It decided to compete on price.

She says ultralow fees make ETFs more attractive as “portfolio building blocks” for the financial advisers who keep more than $1 trillion in client assets at Schwab.

The seven funds that BlackRock cut fees on in November provide basic exposure to broad swaths of the stock and bond markets. Such funds hold 22% of the firm’s ETF assets. Overall, BlackRock has $4.65 trillion in assets, ranking it the largest asset manager in the world.

Mr. Wiedman of BlackRock says ETFs can be profitable even when their fees are low because of immense asset size. “We are in the business of increasing earnings,” he says. “Over time, the revenue growth from volume will outstrip the price cuts in these products.”

For example, the iShares Core S&P Total U.S. Stock Market fund would bring in annual revenue of roughly $800,000, based on expenses of 0.03% and recent assets of $2.7 billion. The equivalent fund at Vanguard has about $400 billion in assets.

BlackRock’s fund got $302 million in new investor money from Nov. 10 to Jan. 26. The average net monthly inflow since the fee-cut announcement jumped nearly 50% compared with the first 10 months of 2015. Some of the increase reflects seasonal factors such as portfolio rebalancing and trading for tax reasons, a spokesman says.

Meanwhile, higher expenses on other BlackRock funds are helping to subsidize funds that have cut investor fees. The iShares MSCI Japan ETF, which aims to track an index of Japanese stocks, has nearly $20 billion in assets and charges investors 0.48%, meaning it pulls in close to $100 million a year.

Relentless pressure

Fee-cutting pressure is likely to remain relentless. Vanguard automatically lowers fees as its funds grow. The firm manages about $3 trillion in assets.

Chairman and Chief Executive F. William McNabb III says Vanguard’s unusual ownership structure limits its ability to offer loss leaders with fees that are lower than their operating costs.

Instead, the firm has spent much of the last year looking for savings in technology, back-office infrastructure and other areas. It recently encouraged holders of brokerage and mutual-fund accounts to consolidate them.

The only escape from the how-low-can-you-go strategy is by tempting investors with higher-fee funds that offer at least the potential to be worth it.

Since the start of 2014, nearly 200 “liquid alternative” mutual funds have been launched to package commodities, currencies and hedge-fund-like strategies into investments for the masses.

Morningstar says the average annual fee on such funds is 1.67%, compared with 1.22% for the average active fund and 0.68% for index funds.

The First Trust Dorsey Wright Focus 5 ETF holds five other specialized funds at a time and can juggle those holdings as short-term indicators recommend changes. The fund, run by First Trust Advisors LP, is less than two years old and charges 0.94% a year.

The ETF outperformed the S&P 500 by more than five percentage points in 2015 and had nearly $5 billion in assets at its peak late last year. Since Jan. 1, it has declined along with the overall stock market and now has $3.8 billion in assets.

Ryan Issakainen, ETF strategist at First Trust, says the fund offers a sophisticated strategy at lower cost than most mutual funds provide.

While investors often are paying less than ever for some mutual funds and ETFs, they need to be careful, says Matt Hougan, chief executive of research firm ETF.com. “It’s going to be like trying to eat healthy in a junk-food restaurant,” he says. “There’s going to be a lot of temptation.”

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