Posted by on Oct 10, 2016 in Articles & Advice, Blog, Columns, Featured, Radio & Podcasts |

Image Credit: Christophe Vorlet

By Jason Zweig |  Oct. 7, 2016 10:40 am ET

This past week, BlackRock, the world’s largest asset manager, cut management fees on some of its iShares exchange-traded funds to as low as 0.04%, or $4 on a $10,000 investment. Charles Schwab quickly followed suit.

But why stop there? Cambria Global Asset Allocation ETF, run by Cambria Investment Management of El Segundo, Calif., assesses a management fee of zero (although the funds it holds charge 0.25%). At least two ETFs in Europe have total expenses of zero, says Deborah Fuhr, managing partner of ETFGI, a research firm in London.

And why stop at zero? Why, my colleague Paul Vigna asked recently, can’t funds pay you to invest?

“Will someone leapfrog us and go to negative management fees?” asks Mebane Faber, manager of the Cambria ETF. “I’d love to see it. There’s a lot of room to wring out the excess fees in the fund industry.”

That’s for sure. As the investment-management consultant Charles D. Ellis has pointed out, fund fees are even higher than they seem.

Funds report their expenses as a percentage of the total amount you invest. But you should size up your fees based not on how much money you happen to have but rather on how much the manager can make it grow. If the market goes up 5%, your fund goes up 6% and the manager charges 1%, your cost of investing is effectively 100%: The fund’s manager has captured all the excess return for itself.

ETFs and other index funds are overturning that ridiculous tradition.

“There isn’t a zero lower bound to expenses,” says Lee Kranefuss, the former global chief executive of iShares, who now runs 55 Capital Partners, an asset manager in Mill Valley, Calif. “A negative management fee is certainly conceivable.”

Because most ETFs funds track markets rather than trying to beat them, their costs are extremely low — and, with the latest iShares fee cuts, are approaching zero. Meanwhile, ETFs can generate revenue by lending their securities to short-term borrowers such as hedge funds or brokerage firms. The borrowers may need the securities to settle a trade or to sell them short in a bet that they will fall in price. The borrowers typically cover the loan with cash collateral of at least 102% of the securities’ market value, and they pay the fund a lending fee as well.

The return on securities lending, among funds that engage in it, averages about 0.03% and can exceed 0.1% on the smaller or international stocks that are most in demand among borrowers.

Think of management fees as a cost, and securities lending as a rebate. As ETF fees fall toward zero, securities-lending revenue can more easily exceed expenses. Once the rebate exceeds the cost, you’re effectively getting paid to own the fund. “Securities lending is your friend,” says Ms. Fuhr of ETFGI.

In the year ending March 31, for instance, the iShares Russell 2000 ETF earned $72 million on securities lending while incurring $53 million in management fees. In 2015, the Vanguard Small-Cap Index ETF (together with its sister mutual fund of the same name) earned $48.5 million and paid only $45 million in expenses.

In principle, says Mr. Kranefuss, a manager could charge a zero management fee and rebate a portion of the securities-lending revenue to the fund. Investors would get paid to own the fund, and the manager could still earn enough to make money for itself.

A spokesman for Vanguard Group says the fund giant doesn’t believe in waiving fees and rebates all securities-lending revenue to its funds. BlackRock says that revenue from securities lending varies so much from year to year that it can’t be counted on to reduce expenses consistently.

There’s another way to reduce the costs of ownership — although not to zero.

Federal mutual-fund regulations permit managers to charge higher fees when they beat the market if, but only if, they also charge lower fees when they underperform.

So how common are these so-called fulcrum fees? Thomson Reuters Lipper tracks 9,908 mutual funds; only 213, or 2.1%, charge them.

Advisor Shares Focused Equity ETF, a fund that launched on Sept. 21, charges 0.75%, which rises to as much as 0.85% if it outperforms its benchmark and goes as low as 0.65% if it falls behind. “If I beat the market, I get a bonus,” says the manager, Eddy Elfenbein. “If I don’t, you get a savings.”

In the past, I’ve argued that investors should receive bonuses from their fund managers for being long-term shareholders, along the lines of the loyalty programs run by airlines and hotels. But shouldn’t fund managers also earn more when they do well for their investors and less when they do poorly?

Of course they should. It’s only fair. As some funds cut their fees closer to zero, they will put more pressure than ever on all funds to become fairer and cheaper.

Source: The Wall Street Journal

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For further reading: Why Do Mutual Funds Cost So Much?