April 6, 2010

ETF Advisor: Dueling Over Expenses

By the end of 2010, there's a good chance that U.S.-listed exchange traded funds (ETFs), will have amassed $1 trillion in assets, roughly 10% of the assets held by U.S. mutual funds. The reasons for ETFs' enormous popularity are obvious: in addition to offering intraday trading, tax efficiency, and access to new investment strategies or exotic asset classes, ETFs are cheaper to own than mutual funds. On average, an ETF charges owners between 0.5 and 0.6% per year in expenses--about half what it typically costs to own a mutual fund.

And having worked hard to inscribe the words "low cost" in the minds of investors, ETF providers have gone a step further recently, challenging one another to the investing world's equivalent of a limbo contest, with discount brokers Charles Schwab and Fidelity cutting their commissions in hopes of one day becoming the king of the ETF hill.

The combination of low annual expenses, no sales loads, and, for some, no-commission trading is drawing in new assets like a magnet to steel. But, in some cases the expenses investors are paying right now have a built-in mechanism to rise should ETF providers decide to stop subsidizing the fees and expenses that funds incur, and that investors implicitly agree to pay when they buy shares. Many ETFs now charge investors a "net" expense ratio, in which the fund provider agrees to either waive or reimburse the fund for a portion of the fund's expenses so that its overall cost will be below a pre-established threshold.

When German insurer Allianz's PIMCO unit brought its first ETF to market in June 2009, it agreed to waive 0.06 percentage points of its 0.15% Total Annual Fund Operating Expenses for its 1-3 Year US Treasury Index Fund (TUZ, Not Ranked), giving investors a "net" 0.09% annual expense ratio. While six basis points is not a gigantic amount, the company said that, with the fund's assets having a relatively low yield of 0.81% in early March 2010, it felt that the fee waiver was important to ensure adequate sales of the fund, which now has about $145 million in assets.

"Our objective is to offer investment products that are competitively priced," said Tammie Arnold, managing director and head of global wealth management for PIMCO, when the fund first came to market. "In the case of TUZ, we're offering a temporary fee waiver that brings down the ER for at least two years. That's an acknowledgment of the current level of yield at the short part of the curve."

Those willing to delve into footnote number three on page eight of the fund's prospectus will learn that the waiver expires in October 2011, though it will be automatically renewed for one-year periods unless PIMCO provides written notice at least 30 days in advance that it won't be renewed. Furthermore, PIMCO is allowed to recoup the charges that it waives for three years in the future, provided that doing so won't exceed the fund's expense limit.

ETFs from companies including iShares, PowerShares, First Trust, Claymore, ALPS, Direxion, WisdomTree, State Street, Van Eck/Market Vectors, ProShares and others all waive a portion of their ETF expenses. In some cases, the amount waived is trivial, as little as 0.01 percentage points, the amount waived by the $72 billion SPDR S&P 500 ETF Trust (SPY Overweight) to give it a net expense ratio of 0.0945%.

In others, however, the approved expenses are far higher than the expenses investors are currently paying. PIMCO's 3-7 Year US Treasury Index Fund (FIVZ, Not Ranked), for example, has a gross expense ratio of 1.15%, with one percentage point waived until the end of October 2010, giving it a net expense ratio of 0.15%. PIMCO says that 1% fee reflects outside legal expenses incurred during the fund's first year of operation. If the fee were actually charged, however, it would represent a significant portion of the fund's interest income; as of the end of February, 2010, the estimated yield to maturity for the fund's holdings was just 2.22%.

The charges waived by PIMCO are tiny compared to some funds. Claymore's Ocean

Tomo Growth Index ETF (OTR Underweight) capped its expenses at 0.6% until the end of December, 2012. The fund, however, lists "Other Expenses" of 4.80% in addition to a 0.5% management fee. Grail Advisors' American Beacon Large Cap Value ETF (GVT Marketweight)--one of the first actively managed ETFs--has a 0.5% management fee and estimated other expenses of 11.6%. It waives 11.31% for a net expense of 0.79%. Its expense cap expires in February 2011.

Such high expenses are the exception, rather than the rule, and most ETFs don't use expense waivers to begin with. However, it is important to remember that the low cost environment ETF investors currently enjoy may not last forever. Fees can rise, and in some cases already have. In December 2009, DB Commodity Services LLC announced an increase in management fees for seven commodity and currency ETFs, ranging from 0.1% to 0.25%, "due to changing regulatory requirements." As expenses go up, the cost advantage of owning ETFs may be slowly disappearing.

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S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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