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Figure 3
Source: ETFGuide.com
Average Fees By Index Strategy
Quantitative 0.64% 0.60% 0.60% 0.65%
Screened 0.47% 0.47% 0.38% 0.58%
Passive 0.34% 0.30% 0.57% 0.45%
0.34% 0.48% 0.60%
Capitalization Fundamental Fixed Weight
Index Strategies And ETF Fees
After categorizing all 304 ETFs by their underlying index
security selection and security weighting methods, I calculated
the average fee for the ETFs in each security selection
strategy and security weighting strategy. Then I calculated
the average fee for each of the nine Index Strategy Boxes.
The results of that analysis are in Figure 3.
Figure 3 shows that U.S. equity ETFs that follow market
indexes (green shade) charge on average 0.30 percent in
annual fees. Thus, it can be said that basic beta exposure
to various segments of the U.S. equity markets cost 0.30
percent on average. That may seem high at first observation,
but recall that the 124 funds in the box include many types
of market index ETFs. In addition to broad market indexes,
there are many subsets, including industry sector funds;
growth and value funds; and large-, mid- and small-cap
funds. The fees charged for sector and style slices of a broad
market index tend to be higher than the fee for a broad
market index ETF. For example, iShares Dow Jones U.S.
Technology Sector Index Fund (NYSE Arca: IYW) has a fee
of 0.48 percent, while the iShares Dow Jones Total Market
Index ETF (NYSE Arca: IYY) has a fee of only 0.20 percent.
At 0.30 percent, basic “Beta” exposure through ETF
investing is relatively inexpensive, while the quest for
“Alpha” through funds that follow strategy indexes is
more expensive. As security selection methods and security
weighting techniques become more complex, the fees
charged by ETFs to manage portfolios to those indexes go
up. There is a direct correlation between the complexity
of the index and the cost of ETF management.
Figure 4
Source: ETFGuide.com
Index Strategy Box Pricing Template For ETFs:
Added Fees For More Complex Strategies
Quantitative 0.35% 0.40% 0.40%
Screened 0.15% 0.25% 0.25%
Passive — 0.15% 0.15%
Capitalization Fundamental Fixed Weight
ETF Fee-Pricing Model Based On Index Strategy
I created an ETF pricing model based on the information
from the Index Strategy Box fee data. The purpose
of the model is to benchmark ETF fees to the complexity
of each underlying index strategy. Investors have been
conditioned to pay higher fees for ETFs that follow alphaseeking
strategy indexes. However, until now there has
been no model for relating different indexing strategies to
ETF fees. The model is a guide to average strategy pricing.
No assumptions are made as to whether any particular
index strategy is worth the average fee charged by ETF
companies to follow that strategy.
There are two uses for an ETF pricing model based on
index strategy. First, investors can compare the fees of
ETFs using like indexing strategies. Second, ETF companies
can use the data to price new ETFs in line with the
competition, and possibly reprice existing ETFs to align
them with the average.
Some adjustments needed to be made to the raw fee data to
smooth out inconsistencies. Those issues existed mainly from
the pricing of security weighting methods; for instance, an
adjustment for ETFs following fixed weight methods because
of the large number of higher-cost quantitative funds that use
a fixed security weighting method. Also, certain index methods
commanded higher-than-normal fees even though their strategy
is similar to indexes by other vendors. For example, ETFs
following fundamentally weighted RAFI indexes were considerably
more expensive than ETFs following other fundamentally
weighted indexes such as WisdomTree products. Once these
adjustments are made, it was possible to create the Index
Strategy Box pricing template in Figure 4.
Figure 4 represents additional fees added to the average
fee for beta-seeking ETFs in a particular category. Recall
that beta-seeking indexes use passive security selection and
capitalization weighting. As an example, the iShares S&P 100
Index (AMEX: OEF) charges a fee of 0.20 percent. If an ETF
were created that tracked an equal-weighted S&P 100 Index,
a reasonable fee would be 0.35 percent. That is the sum of a
0.20 percent market index strategy plus an extra 0.15 percent
fixed-weight strategy fee.
I checked the pricing against different index styles to test
for consistency of Index Strategy Boxes fees across nonoverlapping
sets of data. The three styles I tested were 1) broad
market and large-cap ETFs, 2) mid-cap and small-cap ETFs,
and 3) industry sector indexes. The fees charged by ETFs in
the three different data sets were remarkably consistent with
the pricing template in Figure 4.
An Example Of Fee Pricing With
Index Strategy Boxes
The Index Strategy Box fee pricing template is a valuable
tool that can be used by investors, advisors and ETF
providers. The following is an example of how this pricing
model can be applied.
I analyzed the fees in the U.S. broad market and large-cap
sectors from the ETFguide.com database. The average ETF
fee for beta exposure in this category is 0.20 percent. Once
the cost of beta was known, I applied the Index Strategy Box
pricing template to the 0.20 percent fee. The results are illustrated
in Figure 5.
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July/August 2008