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Exchange-Traded Funds Called Underpriced


One of the advantages of exchange-traded funds is their low expense ratios. However, some industry analysts have suggested that companies could increase these fees given the added benefits that exchange-traded funds offer. The fund companies that offer exchange-traded funds disagree, however, and maintain that they have no plans to raise the funds' fees any time soon.

"ETFs add a lot more value to investors, whether institutional or retail," said Erik Liik, senior vice president and exchange-traded fund specialist at Funds Distributor of Washington D.C. "I think the managers or sponsors of the products should charge for those extra, added benefits. They don't have to go to this fee compression area."

Average expense ratios of exchange-traded funds are much lower than those of mutual funds in general. However, it is arguable whether they are comparable. Exchange-traded funds are most similar to index funds and are passively managed, at least for now. The average expense ratio for passive funds that track the S&P 500 is 18 basis points, according to Deborah Fuhr, vice president and global head of marketing for Opals and exchange-traded funds for Morgan Stanley & Co. International of London. By comparison, the SPDR of State Street Global Advisers of Boston, which also tracks the S&P 500, is at 12 basis points and the iShares S&P 500 of Barclays Global Investors of London is at 9.54 basis points, according to Fuhr.

There is a still larger gap between the expense ratios of exchange-traded funds and those of funds in other categories. For example, the average expense ratio of passive Japanese funds is 193 basis points while the iShares MSCI Japan ETF stands at 84, according to Fuhr.

If exchange-traded funds have lower fees than index funds in general, and they have additional benefits, such as intra-day trading and tax relief, one might reason that they should be able to raise fees, at least as high as those of normal index funds. However, one must take into consideration the expense of exchange-traded funds that does not show up in the form of basis points - commissions. Unlike mutual funds, exchange-traded funds are purchased from other investors, not the fund companies. Investors usually have to pay commissions to buy and sell the shares, just as they would for a normal stock.

"The expense advantage of ETFs is obliterated if you invest small amounts of money," said Christopher Traulsen, a senior analyst at Morningstar of Chicago. The same is true for investors who want to trade frequently. For these investors, the costs may be higher with an exchange-traded fund, despite the product's lower expense ratios.

"[Raising fees on ETFs] might have a different effect on different types of investors," said Jim Folwell, a consultant with Cerulli Associates of Boston. "From an institutional standpoint, one of the reasons they're using these products might be because of the low fees." If that is the case, raising the fees would seem to be a mistake.

Other analysts say that the low fees of exchange-traded funds may not be a big incentive for investors and that the fees could go up without alienating investors.

"I think within some reasonable range as compared with more conventional index funds that that is true," said Donald Cassidy, senior research analyst at Lipper of Summit, N.J. "Typically, these are not long-term investors who have to worry about thirty years of compounding at a high expense ratio."

"You're giving people intra-day trading, margining, you're providing many more features in a product that should command a premium possibly in the expense ratio," said Liik of Funds Distributors. "People don't necessarily make their initial decision based upon low fees. People are willing to pay for quality in the marketplace."

Some analysts feel not only that exchange-traded fund fees could stand to go up, but that at some point they will have to in order for them to maintain their viability.

"When we're talking about exchange-traded funds, the biggest question I have is, 'Can these products charge these very low expense ratios and continue to be profitable?'" said William Chambers, president of Wiesenberger, Thomson Financial of Rockville, Md. "I'm not sure that they can."

Exchange-traded fund sponsors say their fees will not rise. SSGA, which launched the first exchange-traded fund in 1993 and is the developer of the 'Spider' family of exchange-traded funds, has no plans to change its fees.

"They're index funds," said Greg Ehret, principal for exchange-traded funds at SSGA. "The whole concept is that you're dealing with value. You have to offer products at the lowest possible cost. Maybe if you had some complicated product that required more expenses, but right now we're making money."

In fact, Barclays lowered the fees of most of its exchange-traded funds that are based on foreign indices in May.

"We were able to lower fees because of the growing assets of the [exchange-traded funds] and because of our size and scale," said Kerry Steele, a spokesperson for Barclays. While it might be true that companies could raise exchange-traded fund fees and still continue to grow, some analysts may be overlooking the price pressure and competition that the exchange-traded fund companies are imposing on each other.

"I haven't heard that we're thinking about raising ETF fees," said Steele. "If anything, there might be a trend on the downside because of competition."

This notion brings up an interesting paradox. Right now there are very few companies that offer exchange-traded funds. Barclays, evidently, has been able to lower some of its fees because of a wealth of assets. If more companies were to begin to offer similar products, competition would intensify, assets would be harder to come by and the current fee structures might become untenable. At least for now, however, fees appear to be staying where they are.