ETF Investors Say “No Thanks” to Fee Hikes

ETF asset managers seem to think the fee wars are over. ETF investors beg to differ.

ETF inflows hit a healthy $583 billion in 2023, in line with 2022 levels. Recovering markets pushed US ETF assets to a new high.

(Note: All flows statistics exclude converted mutual fund assets, which merely changed wrappers.)

Notably, 60% of that $583 billion went to ETFs that cost no more than 0.10% per year, pushing average asset-weighted expense ratios down to 0.172% per year, further squeezing margins.

And in response? Optimistic asset managers launched a record number of new ETFs, largely focused on active management, options strategies, and geared exposure to single stocks. The defeated ones—more than ever before, except in bear markets—closed up shop. The ones looking to pad ETF revenues raised their fees.

Yes, you read that right. In a marketplace where investors continue to favor the cheapest products, ETF issuers raised their prices. Is this madness, a calculated risk, or a well-informed trade-off? And what does it mean for US ETF investors? A review and analysis of the year’s activity may help frame the question and point to an answer.

ETFs Remain Hot

ETF investors continued their enthusiasm for the product, even though money market funds offered an excellent risk-adjusted return.

ETF Investors returned to basics in 2023, adding to positions in equity and fixed income while dumping commodities and losing interest in geared exposure. Fixed income garnered 34% of the flows, despite representing just 20% of the asset base at the start of the year.

Active is In, Smart Beta is Out

Active management captured market share from strategic beta and idiosyncratic strategies such as ESG and single-exchange focus. Plain vanilla exposure gained ground.

It’s easy to imagine a bifurcated future where the majority of ETF assets track broad-based, cap-weighted indexes, but a substantial minority settles in the hands of stock-pickers or market timers—but not in complex index strategies.

It’s Hard to Make a Buck in the ETF Industry

ETF investors continued to flock to the cheapest products. The most popular funds—ETFs tracking the S&P 500, the total US stock market, and the Bloomberg Aggregate Bond index—cost just 0.03% per year.

A few pricier ETFs caught investors’ fancy, namely:

• iShares 20+ Year Treasury Bond ETF (TLT-US, cost 0.15%), which offers exposure to the riskiest end of the US Treasury yield curve

• JPMorgan Equity Premium Income ETF (JEPI-US, cost 0.35%), which drew in returns-chasers impressed by its 2022 performance record

As the chart above makes clear, JEPI and TLT are hardly typical. Investors were far more likely to buy cheap core ETFs than the more expensive specialized products. This is not encouraging news for the peloton of ETF issuers, who hoped to lure investors with narrow products like TLT or complex strategies like JEPI—only to see their products ignored.

Investors Push Fees Lower

This preference manifested in falling asset-weighted expense ratios across the ETF industry, with equity and bond ETFs costing 0.003% and 0.002% less than they did a year ago.

Some strategies fell even more. Plain vanilla equity fund costs dropped from 0.120% to 0.113%. Active equity fees tightened considerably, from 0.385% to 0.368%, as investors overwhelmingly chose the cheapest providers.

ETF investors have made their preferences clear. Dimensional, JP Morgan, American Century, and Capital group captured 88% of all active equity ETF flows, excluding conversions. The other ETF issuers—164 in the active equity space—fought over the remaining 12%. Those others posted an average (asset-weighted) expense ratio of 0.61%, nearly triple Dimensional’s rate.

Some Asset Managers Give Up

Some ETF issuers sensed opportunity and launched new funds. Others responded to the overwhelming competition by giving up. Both launches and closures were quite high in 2023.

8.1% of the funds trading at the end of 2022 closed shop during 2023. The only years with higher closure levels were the Great Recession in 2008 (8.6%) and the COVID pandemic in 2020 (11.8%).

Others Push Back

In addition to launching and closing funds, ETF issuers also have the option of adjusting their funds’ fees, to increase competitiveness or to boost revenues. Historically, issuers have been laser-focused on competitiveness, but many pivoted hard in 2023. After a decade of fee wars, ETF issuers raised their rates in 2023.

At the end of 2015, US ETFs cost 0.27% per year, on an asset-weighted basis. By the end of 2022, costs had fallen to 0.17%. The overall cost fell again in 2023—but by just 0.002%, or about one-fifth the historic rate—because of issuer activity.

In 2023, 463 ETFs saw fee hikes as 87 ETF providers increased management fees, other expenses, or acquired fund fees. Only 64 ETF providers cut fees in 2023.

Among the largest ETF issuers (those who ended 2023 with $50 billion+ under management), First Trust imposed the largest average fee hikes: 0.016% (asset-weighted, based 12-31-22 and 12-31-23 fees on ETFs that were listed throughout 2023). Fidelity and Dimensional made the largest cuts: -0.015% and -0.012%, respectively.

Investors noticed. The ETF flows gap shows that ETF investors held back on sending capital to funds that raised their fees and accelerated investment in funds that cut investor costs. (The flows gap measures the difference (in dollars) between expected and actual flows, excluding conversions, based on initial market share within a specific ETF segment.)

The chart above measures the entirety of 2023 ETF flows, without regard to the timing of fee changes. Even so, the message is hard to miss. Issuers who defied investor expectations by raising fees lost out on their share of 2023 flows.

Case Study: Russell 1000 Growth and Value Competitors

iShares Appears to Raise Management Fees

The largest ETFs that posted increased headline fees in 2023 are a pair of iShares funds: iShares Russell 1000 Growth (IWF-US) and iShares Russell 1000 Value (IWD-US).

The Blackrock iShares ETFs’ published expense ratios were 18 basis points per year on January 1, 2023, and 19 basis points starting on August 1. Their management fee formulas had not changed, but their associated ETFs’ asset levels had dropped enough to push average fees from 0.1846%, which rounds down to 0.18%, to 0.1879%, which rounds up to 0.19%.

The optics of this minor shift are not great. Few investors read even the first pages of fund’s prospectus; virtually nobody reads the Management section or the SAI, where the nuanced fee information can be found. BlackRock could have chosen to mitigate them by adding a fee waiver, but instead decided to live with the appearance of unexpectedly reversing a fee cut.

Perfect Competitors Exist

Vanguard’s VONG-US (growth) and VONV-US (value) track the same indexes as IWF and IWD. These direct competitors cost 0.08%, as they have since the end of 2019. Investors have noticed these perfect substitutes and have shifted assets to them over the years.

Goldman Sachs, sensing some opportunity for their clients, got into the game on November 29, 2023, launching GGUS-US (growth) and GVUS-US (value). The Goldman products cost 0.12%. As of December 31, 2023, they had not captured significant market share.

iShares’ Market Share Loss Accelerates

iShares’ loss of market share in the Russell 1000 growth/value space has been slow. For the first four years that Vanguard competed in this space, VONG and VONV made little headway. Vanguard’s 0.15% fees were lower than Blackrock’s 0.20%, but Vanguard’s trading spreads were higher, around 0.04% versus 0.01% for IWD and IWF. Vanguard captured just 1% of the market. To many investors, the all-in costs were comparable.

Then Vanguard started cutting fees, down to 0.12% in December 2014 and 0.08% in December 2019. Market share followed, and along the way, trading spreads tightened, trimming the total cost of ownership.

By August 2019, when Blackrock dropped IWD and IWF’s fees to 0.19%, Vanguard had grabbed 5% market share, gaining about 1% per year. By August 2022, when Blackrock published another 0.01% fee cut, Vanguard’s market share had expanded to 10%, a capture rate of 1.6% per year.

Nevertheless, despite charging between 0.05% and 0.10% more than Vanguard for an identical product, Blackrock managed to retain 90% of the client base. Investors who might have wanted to switch to the cheaper Vanguard funds have had ample opportunity; most haven’t budged.

These holders could be highly trading-cost-avoidant (the iShares spreads are currently just 0.01%, vs. 0.02% for Vanguard), trapped by unrealized capital gains or brokerage platform restrictions, or simply prone to inertia. Whatever the reason, it’s easy to see how Blackrock could downplay the risk of alienating their investors by appearing to hike fees.

By the end of July, 2023, Vanguard reeled in an additional 3.8% of the Russell 1000 growth and value ETF market.

After August 1, 2023, when Blackrock published a headline 0.19% fee for IWD and IWF’s fees Vanguard’s capture rate increased to 4.2% on an annualized basis.

Will the Fee Hikes Stick?

We are left to wonder if the migration will continue. Will Blackrock remain satisfied with higher margins on a smaller asset base, or will they pivot and compete on price?

Fee hikes—or the appearance of such—in 2023 were risky moves. So far, it has not paid off. Asset managers who find themselves struggling to meet revenue targets are now at odds with their clients. While a handful of products catch the public’s eye, far more languish. Many issuers may find themselves with a fistful of bad choices: Alienate clients, hobble along with scant revenue, or close the shop.

ETF investors have lots of great choices, with core portfolio building blocks at historically low cost.

Which one would you rather be?

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