Why is ETF Management Fee/Expense Ratio Lower?

The 21st century has seen a phenomenal rise in the popularity of ETFs as an investment tool. From virtually nowhere, it has become a platform that can rival mutual funds/Unit Trust in terms of assets under management (AUM) and diversity of the asset classes it covers. One of the key feature (most will say its benefit) of ETFs is that ETFs, on the whole, usually sport a lower management fee compared to mutual funds given the same asset class and AUM. There are, I think, 4 main reasons why this is so, which I shall explain shortly.

Firstly, ETFs are Index Funds. While there might be some ETFs that are managed funds (are there?), most ETFs are index funds, i.e. the underlying portfolio/prices follow that of published stock indexes. Index funds are in general cheaper to manage as there are fewer trades to deal with. They are, in investment speak, passive in nature. This lowers their brokerage fees and trading slippage. Also, they do not need the service of an army of security analyst to dissect the individual stocks and try to beat the market. Index funds do not beat the market; they’re the market! Given the academia overwhelming evidences that markets are efficient and market timings and security selections are a fool’s errand, index funds in general and ETFs in particular have become the investment tools of choice with more converts flocking to its open arms by the moments.

Secondly, even after accounting for its index fund nature, ETFs are still cheaper in terms of management fees compared to its index mutual funds brethren. One reason could be because in the setup of ETFs, there is division of labour which makes it cheaper to operate compared to a mutual fund. For example, mutual fund companies are required to setup and operate a sales channel. It needs employees and office space to man the phone calls and take in orders. Even if it’s done through the internet via electronic means, mutual funds still need to hire IT staff and expansive computer software and hardware to operate. ETFs do not have such a drawback as it’s traded via brokers. So, you’ll have to consider brokerage fees (if there’s one) as a sale charges on your ETFs you trade. However, brokerages and stock exchanges (the platform on which ETFs are traded) are optimized for such a task and can do it efficiently given the volume they handles. ETF companies can further save money on the accounting and upkeep of customers’ records as it’s offloaded to the exchanges and stock brokers.

Thirdly, ETF management companies can act as authorized participants. Authorized participants are empowered to create or redeem ETF creation units. They serve a useful purpose of bringing the ETF prices in line with the underlying stocks prices that comprise the ETFs. They create ETF shares when ETF prices exceed the underlying stock prices and vice versus. Through this act of arbitrage they generate liquidity and a fairer market where the prices of ETFs are based on the underlying securities. Along, the way, they also generate a tiny arbitrage profit for themselves. Given the depth and breadth of the ETF market, I reckon that this arbitrage profit is fairly size-able if the inflow/outflow of funds to/from the ETFs are huge.

Fourthly, there exists a huge ETF derivative market in the synthetic ETF arena. Synthetic ETFs do not buy the underlying securities with its funds. Instead, synthetic ETFs are swaps that use the funding as collateral and the ETF sponsors promise you the performance of the indexes. I shall dealt with the actual risk of being synthetic in another post but suffice to say, this arrangement increases the flexibility of the fund management companies and allows them to offer the product at reduced management fees since they can earn profits elsewhere as a swap counter-party and sell financial equity-linked products.

Considering these factors, I expect the management fees of ETFs to continue at its current lower level. It’s even plausible that the expense ratios might fall to zero if the ETFs have a really large AUM and profits from businesses such as arbitrage are huge.

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