ETFs: how low can expense ratios go?

Amid falling expense ratios and growing competition, delegates at the Morningstar Investment Conference questioned the viability of some ETF products and the logic of investing in others, writes Christine Benz.

How low can exchange-traded fund (ETF) expense ratios go? That was a hot topic at the recent Morningstar Investment Conference in Chicago, where Morningstar’s ETF team gathered for a roundtable to discuss trends in the industry.

The director of exchange-traded fund research, Scott Burns, lauded Vanguard’s move to launch 20 new exchange-traded funds with rock-bottom expense ratios, including an S&P 500 ETF. Burns noted that ETF prices could go lower still.

“Total market ETFs are commodities and are priced accordingly,” Burns said.

He also said that while price wars in the ETF industry might put pressure on asset managers’ margins, they’re a win for shareholders.

In addition to ongoing price wars, Burns and the team also expect to see more actively managed ETFs launched in the year ahead, but don’t anticipate widespread adoption in the near term.

“I do think this is the year of active ETF launches,” Burns opined, “but not ETF asset gathering”.

Implications of the 'flash crash'

The ‘flash crash’ of 6 May was also a hot topic on the panel, given that its effects were more significant for ETF participants than investors in other vehicles.

Associate director of ETF research Paul Justice said that the freak trading activity underscored the importance of employing best practices when investing in ETFs, including using limit orders to ensure that a trade is executed at the desired price.

Justice also noted the pitfall of using stock trading techniques such as stop-loss orders — which require a broker to sell when a security drops below a given price — when trading broad market ETFs.

“Stop-loss orders may be appropriate for individual illiquid stocks,” Justice said, “but putting in a stop-loss order for a total world market fund is not appropriate”.

Gabriel also pointed out that some ETF investors might not have understood the implications of stop-loss orders before they were triggered on 6 May.

“Having a stop-loss order just means that you will be a seller when that price level has been breached,” Gabriel said. “It doesn’t mean you’ll get that price.”

Burns noted that the dislocations of the 'flash crash' served up some buying opportunities, albeit ones that were so fleeting that most investors couldn’t take advantage of them.

“Somebody traded a total world stock market ETF for a penny that day,” Burns said. “I wish it had been me, and I wish I had been a buyer.”

Commodity blues

The panellists also discussed the viability of exchange-traded products designed to track commodity prices, with ETF analyst Ben Johnson explaining that a phenomenon of contango had greatly limited the usefulness of these securities.

Although the mechanics of contango are complex, the net effect is that it forces exchange-traded products to buy high and sell low each month.

Paul Justice, who oversees Morningstar ETFInvestor’s portfolios, noted that contango had made for a “horrible investor experience” in 22 of the past 28 months.

“Do I want to own any passive commodity strategy? Not any more I don’t.”

Burns also acknowledged the weaknesses of commodity exchange-traded products.

“As much as we like passive investments, this is one situation where passive sets you up to fail. Commodities are one area that could benefit from a little bit of active management.”

Innovations in bond ETFs

Finally, the team discussed investors’ stampede into fixed-income investments, noting that the ETF space had seen the same robust inflows that were evident in the traditional open-end fund world. Burns questioned the wisdom of that move: “I can’t think of a more uncertain time in fixed income.”

Gabriel noted that liquidity and diversification were strong selling points for fixed-income ETFs, but also pointed out that a key drawback, at least until recently, was that investors couldn’t use them for liability matching.

That means investors who need to sell a bond ETF — or any bond fund for that matter — on a given date won’t necessarily receive their principal back.

That stands in contrast to investors who buy and hold individual bonds (assuming their issuers remain financially viable).

However, Gabriel lauded the introduction of new municipal bond ETFs composed of individual bonds that mature on a given date, such as a new series from iShares.

Gabriel noted that the new ETFs enable investors to use some of the same techniques they employ with individual bonds, such as laddering, while also achieving the diversification benefits of funds.

Christine Benz is director of personal finance at Morningstar.