Investors Win as ETF Wars Heat Up

Posted on August 3, 2012 at 4:38 PM PDT by

The ETF wars are once again heating up to the benefit of everyday investors. BlackRock, the leader and pioneer of ETFs through its famous iShares products, is feeling the pressure of increased competition in the ETF space and is likely to lower their pricing.

In a recent earnings meeting, BlackRock CEO, Laurence Fink, acknowledged that aggressively priced products from Vanguard, Schwab and others were eroding their stronghold in the market. BlackRock, the pioneer in ETFs launched its first fund in the early 1990s and quickly grew to market dominance controlling over 60% of the market as recently as 2006. Institutional investors, who require high trading volumes and efficiency, turned to iShares ETFs as their products of choice. Today, however, BlackRock’s supremacy has been battered by Vanguard and Schwab whose highly competitive pricing is winning away iShares customers. They have watched their market share slip to 40% with no clear end to this gradual slide.

A review of current ETF pricing reveals why many investors are moving away from iShares and into other products. Whereas Vanguard offers an emerging market ETF, VWO, with an expense ratio of .20% a year, and Schwab a similar product, SCHE, at .25% in fees, iShares EEM runs .67%, over three times that of the Vanguard offering. This pattern follows across the iShares platform with their U.S. REIT, IYR, costing .47% while Vanguard’s similar product, VNQ, runs a mere .10%.

Today, the average iShares stock fund collects fees totaling $46 per $10,000 invested, compared with $17 for Vanguard, according to S&P Capital IQ. When products accurately track the same indices, cutting prices becomes the primary method to compete, although there are other less noticeable costs.

While expense ratios are the most obvious form of ETF costs, three other types of fees affect your ETF holdings. Index tracking errors can be an invisible cost. Fortunately, ETFs from Vanguard and Schwab have proven reliable in tracking their target indices. A third area to note is trading costs. In recent years, discount brokers have attracted investor dollars by allowing selected ETFs to trade for free on their platform. Schwab and Vanguard ETFs trade for free within their individual brokerages and select iShares trade for free at Fidelity.

While trading costs and expense ratios are easy for investors to understand, they often overlook a fourth and final cost: the bid/ask spread. The “ask” is the market price at which an ETF can be purchased and the “bid” is the market price at which an ETF can be sold. ETFs with lower volumes tend to have larger spreads, which essentially becomes another type of transaction expense. An ETF can trade for free, but because the ETF has poor volume, or weak market maker competition, the bid/ask spread can cost as much as the trading expense on larger transactions.

The good news is that the ETF wars are raging on, driving down pricing in its various forms. Today, investors can build and manage a globally diversified portfolio of low-cost ETFs at pricing levels that only a decade ago would have been unimaginable. One outcome to this war is quite clear – you, the ETF investor, wins.