ETF Wars: Vanguard, Charles Schwab & BlackRock

As the exchange traded fund industry continues to attract investment money, fund companies have pushed fees on passive, index-based strategies closer and closer to zero.

In an attempt to achieve scale and maintain market share, large ETF sponsors have slashed fees on a number of products, with big players like Vanguard Group, BlackRock's iShares (NYSE:BLK) and Charles Schwab (NYSE:SCHW) fighting in a perpetual ETF fee-war that has pushed expense ratios on some popular ETFs down to a 0.03%.

Last year, iShares reduced the fees on a number of its products, with the iShares Core S&P Total US Stock Market ETF (NYSE:ITOT) now showing an expense ratio of 0.03%. ITOT was the cheapest on the block for a brief moment.

Not to be outdone, Charles Schwab lowered fees by one basis point on four of its large-cap ETFs in response to iShares, with the Schwab U.S. Large-Cap ETF (NYSE:SCHX) and Schwab U.S. Broad Market ETF (NYSE:SCHB) both coming in at a low 0.03% expense ratio.

"For traditional market-cap weighted index funds - the return of two funds covering the same market should be equivalent, resulting in beta being commoditized and fund managers left competing only for price," writes Angana Jacob, Global Research & Design at S&P Dow Jones Indices, in a research note. "Thus, the entry barrier becomes the scale, and is no longer about the product. If a fund has USD 100 million AUM and the cost of replicating the market for an additional USD 100,000 is close to zero, in order to maximize profit, the eventual price target should also trend toward that point."

Consequently, Jacob argued that as margins approach zero, larger firms might consider a so-called loss leader approach or waiving fees in an attempt to attract investors, retain accumulated assets and build scale in higher-priced products.

The sponsors have been able to slash the fees largely because of the rapid growth of the funds as the ETF industry has accumulated $2.3 trillion in assets under management.. Looking ahead, the industry may continue to find more opportunities to reduce fees as scale increases. According to a recent PwC survey, global ETF assets are likely heading to $8.2 trillion, with the U.S. portion going up to at least $6.2 trillion by 2021.

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"This pricing strategy would be to offer their core pure passive range for free in order to retain their scale benefits and make their margin on smart beta or active products and other business lines, such as multi-asset solutions," Jacob added. "Many investors also seek to complement their passive low-cost beta with active management using a core-satellite approach."

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Moreover, fund sponsors that opt to go with the ETF fee waiver, loss leader approach may still be able to earning revenue from securities lending. Securities lending is a practice where mutual funds and ETFs pay agents to lend out shares in their portfolios - funds are created with exposure to an underlying basket of securities - to other traders and thereby earn interest. Typically, ETFs lend securities to investors who want to short a stock.

"We show that exchange traded funds can earn significant revenue from securities lending, on order of the size of the ETF's expense ratio," according to a research paper, Passive Investing: The Role of Securities Lending, by Jesse Blocher and Robert E. Whaley. "We also show that ETF managers respond to the securities lending incentives by slanting their holdings toward stocks with higher lending fees."

The research revealed that ETFs could make 23 basis points to 28 basis points per year from securities lending, and if firms are more aggressive with their lending program, securities lending could net as high as 55 basis points to 114 basis points per year.

To put this in perspective, there are currently 1,948 U.S.-listed exchange traded products with an average expense ratio of 0.58%, or 58 basis points.

As ETF sponsors enjoy increased scale and alternative avenues of turning a profit, such as steering people toward higher costing strategies and securities lending, the industry might witness fees go closer to zero. ETF investors will be the ultimate winners, tracking major benchmarks at potentially no cost

This article was provided by our partners at etftrends.com.