Here, on checking, I find that my memory is failing – Gekko actually said that “lunch is for wimps”, as well as “ever wonder why fund managers can't beat the S&P 500? Cause they're sheep, and sheep get slaughtered.” Gekko would have been an early adopter of ETFs, no doubt.
But falling fees are clearly great news for investors, and we’ve had several fund launches over recent weeks where issuers are clearly aiming to undercut the competition, as I wrote about in a blog a couple of weeks ago. That these fee-cut announcements seem to coincide with Vanguard’s recent UK index fund launch isn't coincidental, according to some observers.
But a total expense ratio of zero makes me think two things. One, where is Deutsche Bank making its money? It’s clearly not doing this out of charity. And, two, does it make sense anymore to compare ETFs on the basis of the headline fee?
In response to the first question, db x-trackers made it clear in its press release yesterday that its DJ Euro Stoxx 50 ETF has outperformed the index by 0.61% per annum, post fees, since its launch in January 2007. The extra revenues that have caused this outperformance are achieved, in the words of Manooj Mistry, db x-trackers’ UK head, by “putting the stocks in the index to work” – in other words, lending them out – and by obtaining a better tax treatment of the dividends paid on the index component stocks than could be achieved by a passive investor located in Dublin or Luxembourg, where the ETF would typically be domiciled. By taking a slice of these revenues for itself, the bank can afford to charge a zero headline fee on the fund.
A recent interview by db x-trackers’ Thorsten Michalik with Grace Cheng of DailyMarkets.com goes into this mechanism in more detail, and shows that a large proportion of the performance uplift comes over the dividend payment season each year.
This is all well and good for the investor in ETFs, although there’s of course no guarantee that the extra revenues will continue at such a rate, that the tax arbitrage will remain, or that Deutsche Bank will pass on the same proportion of the revenues now that it’s cut its management fee.
But, turning to my second question above, in view of these operational complexities of ETFs, the headline fee clearly doesn’t tell the full story when one fund is being compared with another. How, then, should we compare different ETFs on a given index?
To answer the question fully, one needs to examine the fund structure (whether it uses physical or swap-based replication), tracking error, counterparty risk exposures, the risks involved in securities lending and who bears them, any structural advantages or disadvantages such as the tax arbitrage referred to above, secondary market liquidity – and, last but not least, the headline fee.
This is a complex topic, to which we’ll return in a forthcoming feature article. But, for the time being, db x-trackers has put the ball firmly in the other ETF issuers’ court. It’s up to them to justify to their investors why they should be paying a management fee.