Vanguard

Investment companies (mutual fund & ETF creators) have been slowly but surely racing to $0. In this case, $0 refers to the prices they charge people to use their fund. Most recently, Vanguard announced that it would be allowing consumers to purchase almost 1,800 exchange traded funds (ETFs) on its online platform.

To understand the significance of the announcement, we have to take a brief trip down memory lane. In 1792, 68 Wall Street brokers met under a buttonwood tree to…well, maybe that’s too early. I’ll try again. In the early 90s, Schwab opened up an online brokerage outlet to allow retail clients to purchase mutual funds without paying a commission. Instead, mutual fund companies themselves paid Schwab from the fund itself. The logic being, funds aren’t actively traded like stocks but Schwab still wanted to get paid. Additionally, Schwab would receive revenue from the fund every year, rather than just when it was bought and sold, and there was a lot of work that happened between the buy and the sell.

Companies like Schwab were also able to collect sub-TA fees, which are additional payments from fund companies to “transfer agents” (that’s the TA part of sub-TA) for some of the background work they were doing on behalf of the fund manager.

Well, it wasn’t long before the ETF, or exchange traded fund, came along. For most investors, an ETF and a mutual fund are indistinguishable. They are both pooled investment structures handled by an intermediary. However, there is a critical difference to investors: ETFs trade intra-day and mutual funds trade overnight, creating a simplified tax structure for ETFs. As ETFs gained popularity, more and more money left mutual funds and went to ETFs. However, people still wanted to buy them for free, or at a very low cost. This is a problem for companies like Schwab, Fidelity, or e-trade, as ETFs do not have 12b-1 or sub-TA fees! There is no way for the brokerage firm to charge the fund company.

Initially, brokerage firms allowed ETFs on their platform but eventually, as more money flowed from funds to exchange traded products, firms were forced to address the lost revenue. Distribution agreements and “shelf space” agreements were born. A distribution agreement is a contract with a mutual fund company like Blackrock and a brokerage firm like Fidelity, where the fund company pays the broker an annual fee to be listed on the company’s platform. Shelf space is similar but distribution fees are typically based on a percentage of money in the fund, while shelf space agreements are flat.

While this was happening, ETF and mutual fund managers continued to slash prices to stay competitive in the marketplace. Since the early 90s, average mutual fund costs have declined by roughly 20% and ETF prices have dropped by almost 50%! This battle has intensified in the past 36 months with Fidelity lowering its index ETF prices below Vanguard and most recently, another round of price cuts at Blackrock.

I know I said a “brief trip down memory lane,” didn’t I? Well, in order to understand Vanguard’s move, you have to understand what brought it here. There is an interplay between fund company, broker, and investor that is creating a strange dynamic. In order to attract more consumers, ETF companies are forced to lower prices, but in order to exist on a broker’s platform they need to pay increasingly higher fees to said broker, or risk being removed. Meanwhile, Vanguard has experienced a meteoric rise in popularity despite refusing to pay any fees to brokerage firms, which is why many online investment retailers and brokerage houses don’t offer Vanguard funds!

Now that Vanguard has sufficient market share, it can make a bold move like offering 1,800 ETFs to be purchased on its platform, including funds from its competitors! Eighteen hundred is at least five times more ETFs than any of Vanguard’s major competitors. So, why do it, what’s in it for Vanguard? Well, as consumers have grown increasingly fee conscious, Vanguard stands to look extremely competitive. ETF providers can only lower their fees so much. Remember, they still need to pay other brokerage platforms money to be listed. Vanguard isn’t paying those fees so it has no issues listing a competitor’s fund next to its own. The breadth of investment offering will drive new consumers to the platform, where Vanguard can control the price conversation and potentially gain additional market share by offering lower cost options.

At best, this will force the entire industry to rethink the way they charge consumers. Hopefully, creating a much more transparent conversation about investment costs.

Smart Beta

To me, smart beta is the bitcoin of 2018. At least, insomuch as it relates to my blog. Granted, no one calls me up and asks me about smart beta, as they did with bitcoin, but I certainly read about it as much, if not more. And smart beta is almost as dumb as bitcoin.

Smart beta enthusiasts would argue that using factors in investing is superior to blindly buying an index and relying on market capitalization. Smart beta funds look to measure what has created market outperformance in the past and use that knowledge to achieve outperformance in the future.

Smart beta critics argue that what has worked in the past, won’t necessarily work in the future. Also, that one reason these factors created outperformance is that they weren’t widely traded on, and at best, eventually smart beta will render itself obsolete.

Smart beta cynics will tell you that these fund companies are just looking for a fancy way to explain higher fees because all the other ETFs are getting cheaper and it’s harder for fund companies to make obscene amounts of money. This is sort of where we started, right? Investors used to pick a “really smart fund manager” that they believed could outperform the market. Today, investors are looking for passive index exposure to match market returns and this isn’t worth nearly as much money as a “really smart fund manager.” Fund companies know this, but they also know some work is worth more than no work, so they just replaced the “really smart fund manager” with a “really smart computer program” and added a few extra basis points to their expenses.

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