If something sounds too good to be true, it probably is.
There's a dark side to the wave of cost cutting that's swept through the exchange-traded fund industry over the last 12 months. While every mom and pop in America can now pay nothing to buy an ETF through their favorite broker, and an extra nothing to cover its annual management fee, concern is mounting that there are catches to this bargain that could surprise investors.
Brokerages have been fairly upfront about compensating for their lost commissions with interest revenue, but managing a fund — even one that tracks an index — isn't free either. It costs about $250,000 per year to run an ETF, with the exact amount depending on what the fund owns, which service providers it hires, and the issuer's broader business. But one way or another, whether its legal costs, aggressive up-selling or extra risk-taking, investors could wind up paying.
"This isn't UNICEF, there's a cost associated with doing things," said Matt Bartolini, head of SPDR Americas Research at State Street Global Advisors, referring to the well-known children's charity. "My first question is how are these costs being covered?"
Corner Cutting
The answer? It depends. A fund's management fee typically covers the cost of licensing or creating an index, admin like record keeping and prospectus mailings, as well as the expenses associated with running a board of directors. Issuers that offer products for free still have these costs, but they have more reason to try to reduce them.
One place where efficiencies could be made is in the legal department, which could hurt investors in the event of a lawsuit. Other savings could be made by constructing indexes in-house or licensing lower-cost alternatives, hiring second-tier custodians, or limiting any sales presence or advertising budget. These economies could result in damaging oversights, or increase the likelihood of the fund closing.
"I would be concerned about the compliance and legal aspect," said Sam Huszczo, the founder of SGH Wealth Management, a $170 million investment adviser based in Detroit that uses ETFs. "Those are the two areas where I could see corners being cut."
Salt Financial, which pays investors to buy its fund, tracks an index of stable companies and only swaps out two or three names per quarter, which lowers transaction costs, according to co-founder Alfred Eskandar. In October, the company said it planned to move the ETF to a trust maintained by U.S. Bank to reduce administrative and operational complexity. The change will also save money, although Eskandar said investors will not be exposed to additional risks. He hopes the lack of fee will encourage investors to try the fund, and that they'll stick around due to its performance.
