Can BlackRock Thrive Even as Fund Fees Fall?

Finance is starting to look a lot like charity work. 

Vanguard runs some of the largest funds in the world, but it doesn't care if it makes money because it's owned by the people who invest in its funds. Discount brokerage Robinhood wants to make every single stock, option, and ETF trade completely free, siphoning off the most cost-sensitive brokerage accounts from other discount brokers.

The declining cost of being invested in financial assets is great for investors, but it's destroying what were once some of the greatest business models in existence. Some of the best investments of all time have been the companies that make their money helping others invest -- think BlackRock (BLK +0.00%), T. Rowe Price, and Eaton Vance. The irony is that at almost any point in time, you would have earned higher returns by investing in an asset manager's stock than the funds it manages.

As fund fees fall, and the switching costs of moving from one fund company to another evaporate, one wonders if passive fund managers, which have blossomed by competing with more expensive active funds, will come under pressure as they begin to compete more aggressively with other low-cost passive funds.

BlackRock's edge

Most investors understand that when it comes to index funds, expense ratios are often the biggest point of differentiation. If two index funds both track the performance of the S&P 500, then picking the best fund often comes down to picking the cheapest fund.

That means that being the low-cost producer is the ultimate competitive advantage for index fund managers. But Vanguard has that advantage largely locked down. Vanguard has scale (more than $4.5 trillion in assets under management) and doesn't need to generate a profit, so it can continuously reduce fees on its index funds as they grow, which it does with regularity. 

Index mutual funds are virtually identical, but for now, managers can still carve out an edge in exchange-traded funds (ETFs). Because ETFs are bought and sold like stocks, liquidity matters. When more people use a particular ETF, the more useful it becomes. Popular ETFs can get away with charging higher fees because short-term traders, not long-term investors, make up the majority of ETF trading volume. Traders place more value on the ability to buy and sell quickly without moving the market than they do on getting the absolute lowest fee on a fund.

BlackRock's iShares Russell 2000 ETF is a shining example of how a fund can get away with an above-average fee if it offers more liquidity than lower-priced rivals. It's a simple index tracking fund, but because it is the biggest and most liquid, it carries a fee four times more expensive than its least expensive competitor. 

Data sources: Fund sponsors, ETFdb, calculations by author. Average daily trading volume is calculated by multiplying last close price by average shares traded.

If you're an institutional investor who needs to be able to move millions of dollars in and out of an ETF in minutes, iShares' fund is the only game in town. That enables BlackRock to charge an above-average fee on the fund, and still win the bulk of ETF assets that track the Russell 2000 index. 

It's hard to stay on top

The exchange-traded fund industry favors incumbents, as the most popular and most successful funds are often the oldest. But that's changing, particularly as new entrants race into the space with cutthroat pricing that wins over buy-and-hold investors, and, eventually, traders, too.

ETFs that employ simple strategies are most at risk of disruption. Last year, Goldman Sachs (GS +0.59%) filed with the SEC to create an equal-weighted large-cap ETF, which many believed was designed to take aim at the Guggenheim S&P 500 Equal Weight ETF (RSP 0.08%), one of the biggest cash cows in the ETF industry.

Guggenheim's ETF is decidedly simple. It invests in all S&P 500 stocks on an equal basis, so that each stock makes up roughly 0.2% of the fund when it is rebalanced. In contrast, most S&P 500 index funds weight holdings based on their size, so that the largest companies make up a larger share of the fund. Guggenheim's twist was hardly revolutionary, but it was the only company offering the strategy, so it could charge a hefty 0.40% fee on assets in its fund each year.

Goldman Sachs saw the equal-weighted corner of the ETF world worth fighting for, and Guggenheim saw the investment bank's new product as being a capable competitor. Guggenheim had little choice but to slash its fee on its fund to 0.20% of assets to ensure it kept its top spot. There aren't many businesses where the emergence of one new competitor requires the market leader to slash prices by 50%, but ETF management is one such business model.

Fund fees, once measured in dollars, are now looking like pocket change. Image source: Getty Images.

Fund sponsors are also cannibalizing their own highly profitable funds in a bid to remain competitive. iShares' most profitable ETF is the iShares MSCI Emerging Markets ETF, which carries an astonishingly high expense ratio of 0.69%. The fund paid iShares more than $207 million in advisory fees last year, according to its most recent annual report. iShares can charge a high fee on the fund because it is still about five times larger than its second-largest competitor in terms of trading volume, though the gap is closing.

The question is how long this high-priced ETF can retain its edge in daily trading volume, particularly since there are two competing funds with lower fees that are soaking up more trading volume and assets with each passing day. Amusingly, the biggest competitive threat to iShares' highly profitable ETF is another iShares ETF.

Data sources: Fund sponsors, ETFdb. Average daily trading volume is calculated by multiplying last close price by average shares traded.

iShares' original emerging markets ETF has an incumbency advantage, but it has to carefully balance the desire to extract as much as possible in fees without giving up too much in the way of market share. As assets and daily trading volume in the most profitable emerging markets ETF flatten out, lower-cost funds are gaining more in assets and trading volume, and it's only a matter of time before iShares will have to slash fees if it wants its high-priced fund to remain the market leader.

Who wins in a passive world?

It's almost certain that passive funds and ETFs will have a greater share of investment assets 10 years from today. But growth in assets doesn't necessarily beget profit growth for fund managers. 

Data source: iShares annual reports, author calculations. Fees divided by reported average assets under management for the year.

In the last five years, iShares' assets under management (AUM) soared at an average rate in excess of 18% annually, helped by inflows and rising stock prices, but average fund fees have dropped precipitously. I estimate iShares' average fee has declined roughly 24% from 0.34% of assets in 2013 to 0.26% of assets in 2017, a trend that seems almost certain to continue.

At the margin, the oddball volatility ETF might be able to enjoy some pricing power, but the reality is that the vast majority of all ETF assets are destined to be invested in simple, plain-vanilla index funds that track "boring" indexes like the S&P 500 or Russell 2000. And it's in these ordinary index ETFs that fund managers are most competitive on pricing, which is why I think BlackRock and other passive fund managers may be at a tipping point: Fees may fall faster than assets pile up, weighing on profits.

Some companies get big and make their investors rich. Others get big and make their customers rich. Increasingly, passive fund managers appear to be more of the latter than the former.