The COVID-19-Induced Volatility of 1H2020 Accelerated ETF Fee Compression

In the funhouse, mirrors reflect at odd angles, but the rules of gravity still apply. So too with ETFs so far this year. In the first half of 2020, U.S. ETF investors responded to volatility with contrary impulses: flocking to bonds while also embracing high-risk tactical tools. Strategies like ESG and active management gained market share at the expense of smart beta and thematics. Yet gravity—the relentless force of fee compression—carried on uninterrupted. Those who expected market volatility to push investors to seek out high cost “steady hands” have instead found the preference for low-cost funds accelerating.

Both the oddities and the accelerated long-term trends deserve a deeper look as each has repercussions for investors and asset managers.

The ETF issuer-level flows gap provides headlines. The flows gap is the difference between expected and actual flows. Expectations are based on each issuer’s market share at the start of the year scaled by total flows through June 30, 2020.

Among low-cost, large-scale providers, Vanguard ran the tables by pulling in $36 billion more than its market share projection while BlackRock fell short by $38.4 billion. Vanguard’s asset-weighted expense ratio of 0.06% was less than one-third of BlackRock’s 0.19% and less than one half of State Street’s 0.14%.

Meanwhile, 2020’s wild spring revived investor interest in some of the ETF industry’s sharpest knives: tactical-use ETFs focused on gold, geared exposure, and crude oil. This becomes apparent in the flows outperformance of the World Gold Council (sponsor of the SPDR Gold Trust (GLD-US)), Geared ETF providers ProShares and Rafferty Asset Management (issuer of Direxion ETFs), and Concierge Technologies (United States Oil Fund (USO-US)).

Invesco’s tactical flows star Invesco QQQ Trust had the fifth largest flows YTD at $10.5 billion. However, $8.3 billion outflows from Invesco’s “smart beta” products such as Invesco S&P 500 Low Volatility ETF (SPLV-US) led to an overall flows gap.

The tactical ETF issuers’ success, and BlackRock’s relative weakness, led to a minor decrease in industry concentration. As of June 30, 2020, the top 10 providers held 94.17% of all U.S. ETF assets, which is down from 94.35% at the start of the year. The Herfindahl-Hirschman Index, used by the U.S. Department of Justice to assess industry concentration, fell from 24.6% to 24.1%, edging away from the 25.0% level that flags high concentration.

The flows gap chart misses one critical event in YTD ETF flows: the surge into fixed-income ETFs. Capital from actively-managed bond funds sought safe harbor in bond ETFs. Fixed-income ETFs attracted $95.8 billion, far outstripping the $57.4 billion that flowed to equity ETFs. For context, the Fed’s ETF purchases totaled less than $8 billion in mid-July.

Bond ETF flows changed the ETF landscape. At the start of 2020, bond ETFs held 19 cents out of every U.S. ETF dollar. By June 30, that number rose to 22 cents.

The ETF headlines were striking in the first half of 2020. But headlines did not capture the one trend that will have the longest-term effect on investors and asset managers: 2020’s accelerated fee compression in equity and fixed income.

Both asset managers and investors drive fee compression. ETF issuers slash funds’ expense ratios, competing for the low-cost leader mantle. Investors leave high-cost funds in favor of cheaper alternatives.

ETF investors are now paying $388 million less per year than they would have last December. 32% of the savings are directly attributable to fee cuts while 68% of the savings came from investors directing cash to a low-cost ETF or moving capital from an expensive ETF to a cheap one.

Migration to ever-lower-cost products accelerated in the first half of 2020 in equity and fixed-income ETFs, the two largest asset classes that claim 95.6% of all U.S. ETF assets under management. The asset-weighted expense ratio for equity funds dropped from 0.180% to 0.169%, a pace 37% higher than the 2018 and 2019 rates. In fixed income, the fee compression rate ran 59% higher. In the chart below, it’s easy to mistake the six months of 2020 for a full year.

On a more granular level, fee compression can be seen in the shifts in market share within each ETF’s FactSet segment. A segment is a grouping of direct-competitor ETFs, defined by a common geographic and economic exposure. Examples include Equity: U.S. Large Cap and Fixed Income: U.S. Government, Treasury Investment Grade Ultra-Short Term.

Here is how fee compression works. In each case illustrated below, two ESG funds competed within a specific segment of the U.S. fixed-income market. The cheaper one attracted more flows, capturing market share and driving average fund expenses lower in the process.

*ESCR changed strategies to ESG and dropped its expense ratio from 25 to 15 bps on May 12, 2020

Source: FactSet

This consumer preference for cheaper funds within a segment and strategy has been widespread so far in 2020, across nearly all strategies in equity and fixed-income ETFs. The cost spread between funds that gained market share and those that lost ground or closed entirely is evident in 10 of the 12 equity strategies with assets of $10 billion or more, and seven of the eight fixed-income strategies with $1 billion or more.

Tactical investors, who are often willing to bear higher fees in exchange for prime liquidity, certainly had their moment in the first half of 2020, increasing the market share of high-cost providers. But their impact was nowhere near strong enough to counteract the secular trend that is pushing ETF expense ratios to zero.

The coronavirus-induced volatility of the first half of 2020 accelerated fee compression. High-margin strategies were not spared. Some, such as active management, ESG, and dividend strategies, saw asset-weighted expense ratios fall faster than average. Even in the funhouse, the law of gravity applies. When the floor warps, falling objects gain momentum.