Vanguard raises the possibility of free ETFs

April 2, 2013 1:08 pm

Vanguard raises the possibility of free ETFs

By Madison Marriage

Exchange traded fund providers have room to reduce charges to zero and could even pay clients to invest in their products, according to US firm Vanguard. Nick Blake, head of retail at Vanguard Investments, says revenues from securities lending alone are sufficient to make ETFs profitable. Mr Blake says: “I would like to think the cost of investing [in ETFs] could come down to zero. “There will always be a fixed cost in there, but if [a firm’s asset] volume is big [enough], the total expense ratio can come right down.” Vanguard, which has been building its footprint in Europe and now has ETFs registered in Ireland, the UK and Switzerland, currently charges investors an average management fee of 28 basis points.

However, Mr Blake, who was recently speaking at a conference in London, says his firm’s average management fee could decrease further due to the revenues physical ETFs can generate from securities lending.

Mr Blake says: “In theory, we could pay investors to invest in us [as] stock lending can [create] a negative TER.”

Mr Blake’s comments come as the battle among US ETF houses to undercut each other on fees spreads to Europe, with French provider Lyxor slashing fees on seven of its flagship equity ETFs last October.

The only groups offering lower expense ratios than Vanguard in Europe include Amundi, at 26 basis points, Commerzbank, at 25 basis points, and ETFLab Investment, at 17 basis points.

French bank Société Générale, meanwhile, has the highest average expense ratio, at 135 basis points.

The average TER in Europe is 38 basis points, according to consultancy ETFGI.

Nizam Hamid, an independent ETF consultant, agrees that the “revenue that is made in securities lending can help offset the TER”.

He says BlackRock’s iShares Euro Stoxx 50 ETF, for example, carries a TER of 35 basis points but generates securities lending returns of 22 basis points, bringing net TER to 13 basis points.

However, Mr Hamid says there are “very few funds where you will get enough securities lending revenues to completely offset the TER”.

“It can happen in odd and exceptional cases, but it is quite hard to suggest it could be a strong ongoing theme,” he says.

Experts are aware of only one fund, the Deutsche Bank Euro Stoxx 50 Ucits ETF, that charges a 0 per cent TER.

Ben Seager-Scott, senior research analyst at BestInvest, agrees that firms will struggle to drive “massive returns” from securities lending and bring TERs down to zero. “It’s a pipe dream,” he says.

He adds: “Encouraging firms to do more [securities lending] is not very wise [as] lending out more of an ETF effectively turns physically replicated ETFs into synthetic ETFs.

“It’s a nice idea, but the reality is that people want to invest in very liquid [products], and there is not enough demand for securities lending that it would be feasible to [bring TERs down to zero].”

Mr Hamid adds that it may become increasingly difficult for ETF providers to pick up securities lending revenues as Europe moves towards tax harmonisation.

He says: “One of main drivers for borrowing securities is going to diminish and lower returns from securities lending.

“It is overly simplistic to say there will be enough securities lending all round for TERs to go down to zero.”

There were doubts last year about whether ETF providers could continue earning securities lending revenues as the European Securities and Markets Authority said all revenues would have to go to the fund “net of operational costs”.

However, Esma published further guidance last month that seemingly allows ETF providers to carry on benefiting from revenue sharing agreements.