The race to the bottom in ETF fees is packing dynamite around the equity market

The rapid ascent of passive investment, particularly in exchange-traded funds (ETFs), has prompted a record swell of inflows into low-cost index funds this year. By the end of September, year-to-date net inflows for ETFs globally had reached $433 billion, increasing 79% from the same period in 2016. The upsurge has been propelled by favourable economic conditions and unprecedented cuts in fees by some of the largest ETF providers, including Blackrock and Vanguard.

Fierce competition has intensified as the asset class has grown, resulting in a significant reduction in fees from ETF providers. For example, Blackrock dropped its access fee for its iShares Core S&P 500 IVV ETF in October 2016, to 0.04%, with Vanguard following suit in 2017, dropping its S&P 500 VOO ETF fee to the same price. Price competition alone has had a major knock-on effect for the investment industry. Low fees are perpetuating huge capital inflows into passive vehicles, which has also been aided by low interest rates and a benign economic environment. All factors combined have pushed up equity valuations, far beyond normal levels.

According to a recent report by Deutsche Bank, global assets under management of all exchange traded products currently stands at $4 trillion. More than 5,000 separately traded ETFs are now available to investors compared to 1,600, nine years ago.

Gloabl ETFs

It’s difficult to make a case against passive investing, especially given the market climate over the last decade, with rock-bottom fees and the S&P 500 Total Return Index up 367% since its low in March 2009. It’s also easy to see why ETFs are so popular – they are cheap, transparent and allow investors the ability to trade intra-day.

However, passive investing provides no distinction between good and bad companies. As money flows into ETFs, everything rises together and poorly run businesses increase in price with no regard to their real value. If stock prices rise together, active management struggles, passive investing becomes even more popular and the over-pricing of bad companies is exacerbated. However, once this extended bull run turns bearish, the first thing that will happen is that quick money will be taken off the table via ETFs, effectively compounding the sell-off. The secondary impact will be that poorly run companies will fall faster and harder as active managers come back into favour, increasing the pain of the passive investor.

For all the positive attributes of ETFs, they could be an explosive contributor to the next financial crisis.