Investors Celebrate the Legacy of Jack Bogle

Jack Bogle, Vanguard founder and the father of low-cost index investing, famously declared, “in investing, you get what you don’t pay for.” Bogle championed low cost and simplicity, endearing him to investors and revolutionizing the asset management industry. Since his passing this month at the age of 89, he has been widely celebrated for his contributions to the investment industry.

However, the finest celebration of Jack’s life work can be found in the increased size of investor returns, reflected in the historical decrease in investment management fees paid. Investors have been paying silent tribute to Jack Bogle for years, by flocking to cheap, broad-based, simple index funds.

We can celebrate Jack Bogle’s life by the numbers, by measuring the decline in investment fees and the rise of Vanguard-style investing across the ETF industry. 2018 was a banner year for the trends Jack Bogle set in motion.

2018 showed that, once again, low cost and high efficiency are winning investors’ hearts, minds, and wallets, while expensive, inefficient products are losing out. Winners are cheap ETFs, while losers include active mutual funds, many hedge funds, and even expensive ETFs. Asset managers continue to slash expense ratios, while investors pile into low-cost funds and shun expensive ones.

The Race to Zero

Fee compression, also known as the fee war, continued at a rapid pace in 2018. ETF issuers continue to cut fees as clients seek out ever-cheaper options. Fidelity’s 0.00% fee mutual funds grabbed headlines – and some $2.6 billion in assets – by winning the race to zero.

The ETF price tag keeps falling. What was cheap in 2017 looked a bit rich in 2018, as the threshold for attractive pricing continued to drop. As investors rewarded low expense ratios, asset managers played catch-up by cutting fees. FactSet documented 283 fee cuts among U.S.-domiciled ETFs, excluding geared funds. That’s 13.5% of the universe, by count. While many cuts were minor, some were quite dramatic, as depicted in the chart below.

Cheap Thrashes Expensive

Investors rewarded cheapness and punished high-cost funds. The 2018 number one ETF by inflows, iShares Core MSCI EAFE (IEFA-US)’s cannibalization of its higher-priced sister fund, iShares MSCI EAFE (EFA-US), provides a perfect example of the ETF price war in action.

In 2018, 77 U.S.-domiciled funds that competed in the developed-ex U.S. equity total market segment. Four funds dominated the segment, with 81% of segment assets at the start of 2018. Three of the four are competitively priced, at 0.06% to 0.08%. Still, at the beginning of 2018 EFA dominated the segment, despite its annual cost of 0.31%. That domination ended in 2018.

IEFA, Vanguard’s FTSE Developed Markets (VEA-US), and Schwab International Equity ETF (SCHF-US) toppled EFA, taking in $34.68 billion while EFA suffered $10.63 billion in net redemptions. 

2018 Market Share Changes and Expense Ratios, Top Four Developed Markets Ex-US ETFs

Source: FactSet

At 31 basis points, EFA-US can no longer compete with rivals charging six, seven, or eight basis points. 

2018 Shifts in Market Share Reflect Movement to Lower Cost ETFs

This same story played out in segment after segment, asset class after asset class, across all investment strategies. Dollars flowed to cheap funds while expensive ones lost out. This resulted in a shift in market share from costly funds to cheap ones.

The stakes got higher – actually, lower - this year. On an asset-weighted basis, the bar for cheapness dropped over the course of 2018. Nowhere is this more obvious than in the alternatives asset class. Back in 2017, alternatives ETFs that gained market share cost an asset-weighted average of 0.86%, while the losers cost 0.92%. Over 2018, investors flocked to alternatives funds costing, on average, 0.79%; market share losers’ expense ratios averaged 0.86%. Price tags that attracted assets in 2017 became undesirable in 2018.

The fee war hit the bread-and-butter asset classes just as hard. Equity ETF market share winners’ price tags fell to an average of 0.16% in 2018, down one basis point from 2017. Equity ETF market share losers’ costs dropped one basis point, as well, to 0.23%. An equity fund with a 0.20% price tag could be considered mid-range in 2017 but was more on the edge in 2018.

The table below illustrates how the fee war played out across asset classes in 2018. 

Asset-Weighted Expense Ratios for Funds That Gained/Lost Market Share, By Asset Class and Year

 Source: FactSet

In the largest segments, those with assets of $100 billion or more, the price war was fiercer still, with market share winners costing 0.11% and losers 0.19%, on an asset-weighted average basis. Funds that closed up shop for good cost 0.33%.

That bears repeating. In a space where actively managed mutual funds routinely charged 1.00% or 1.25% a decade ago, ETFs that charge 0.20% are now uncompetitive.

A More Expensive Mousetrap?

Not long ago, in 2014 and 2015, ETF issuers, having written off “cheap beta” as unprofitable, expected to maintain pricing power by offering complex strategies that were “smarter” than the vanilla funds. They turned out to be half right. While the complex strategies have caught on with some investors and do carry higher expense ratios, the price war is as active among complex funds as it is among the simple ones.

Two examples – one set of value funds, and one set of money market substitutes – will make the point.

In 2018, Vanguard Value ETF (VTV-US) overtook iShares Russell 1000 Value ETF (IWD-US) as the largest U.S. value ETF thanks to its $8.5 billion of inflows in 2018. VTV’s price tag is now 0.05%, down from 0.06% in 2017. IWD costs 0.20% per year. That’s no longer an attractive price point.

Similarly, cash equivalent segment saw J.P. Morgan displace its long-established, twice-as-expensive PIMCO competitor. All funds in this segment are actively managed, with median fees at 0.30%. JP Morgan’s Ultra-Short Income ETF (JPST-US) costs about half that, 0.18%. In 2018, JPST took in $5 billion in flows, beating out segment leader PIMCO Enhanced Short Maturity Active ETF (MINT).

Strategic VTV and active JPST are emblematic of their strategy types, as illustrated in the table below. Strategic, so-called “smart beta,” funds that increased their market share dropped from 0.29% to 0.21% over the past year, while active funds that increased their market share now cost 0.85% on average, 0.04% less than they did in 2017.

Fee Compression in U.S. Equity Funds, By Investment Strategy Group

 Source: FactSet

These complex funds are heading towards zero, albeit from a higher starting point.

Cash and Core

Fee compression is not the only trend driving investor behavior. During 2018 investors shifted market share towards Bogle’s ideal core portfolio building blocks and classic “style box” funds and away from funds more suited to tactical use. The shift becomes obvious when looking at the top ten inflows and outflows.

Top 10 ETFs by Inflows

Top 10 ETFs by Outflows

Source: FactSet

Half of the biggest losers were tactical funds. These narrow-exposure funds hone in on a particular market or apply a targeted strategy. Think real estate, high yield bonds, sectors, or plays like momentum and low volatility. The core funds that faced outflows all have direct competitors that cost a fraction of the price.

The winners, on the other hand, were overwhelmingly broad-based funds that covered a wide geography, such as the U.S., developed markets, or emerging markets. These are classic buy-and-hold Bogle building blocks that form the core of portfolios across the U.S. And yes, they are cheap.

Given December’s corrections, it is unsurprising that ETFs which can substitute for money markets funds were a smash hit in 2018. Across the U.S.-domiciled ETF landscape in 2018, cash-like ETFs punched way over their weight, growing 18 times as fast as their starting AUM would have suggested.

2018 Performance of U.S.-Domiciled ETFs

 Source: FactSet

Portfolio building blocks, whether slice-and-dice “style box” funds or wide-ranging all-in-one funds, increased their market share. The tactical funds, i.e. thematics, most “smart beta,” and the narrow-focused funds, were left behind.

Conclusion

2018 saw a continuation of trends that strongly favor the consumer and threaten all but the most efficient asset management businesses. Flows tell the story of where the market is going. This year we saw continued fee compression, diminished opportunity for newcomers, and the dominance of core-type funds that remind us all that simple, cheap portfolios have become the new industry standard. The path to 0.00% may be longer for some product types, but the direction is clear.

In this new zero-cost world, portfolios – not just funds, but full asset allocations – may well be available at marginal cost, or nearly nothing. That’s an amazing legacy, Mr. Bogle.