As competition for AUM growth among the world’s largest ETF managers has intensified over the past few years, triggering a ‘race to the bottom’ in passive-fund fees, many suspected that it was only a matter of time before a fund manager hit upon the genius marketing tactic of simply offering investors in a fledgling fund payment for AUM.
That finally came to pass last week, when the hitherto unknown Salt Financial introduced a new low-volatility equity ETF by offering to pay out 50 cents for every $1,000 invested in the fund until it hits $100 million AUM (alternatively, the offer would apply to all funds invested before April 30, 2020, whichever comes first).
The hope is that investors will be so happy with their returns (or at least indifferent enough to their portfolios) that they keep the money invested even after Salt starts charging a 29 basis point fee.
But this latest in a cluster of warning signs (the Salt fund’s launch, following by only a few weeks SoFi’s introduction of a zero-fee ETF, which relied on a similar gimmick) has renewed speculation that the end of the passive investing bubble might be nigh at hand, which could have seriously negative ramifications for broader markets (even though the rally has continued absent of flows). State Street’s recent mass firing of senior managers could be one clue.
At the very least, the trend is challenging the old Wall Street mantra that ‘a small number on a big number is still a big number’. And since nobody wants to work for free, one Sanford C Bernstein analysts’ prediction that passive investing would one day prove to be ‘worse than communism’ is looking increasingly prescient.
Echoing this theme, more analysts are beginning to question whether we’ve hit ‘peak passivity’…
…as the passive-management industry’s breakneck post-crisis growth appears to level off. And though stocks have powered higher in the new year, they remain off their all-time highs, which could pose imminent problems for fund managers as the tide begins rolling out.
As BBG’s Eric Balchunas put it, the trillions that have poured into passive funds could easily become more of a burden than an asset.
All told, it’s never been cheaper to invest in ETFs. But for some, it’s a sign all is not well for the passive-investing boom as average fees fall toward zero.
“It could actually backfire” for asset managers, says Eric Balchunas, an analyst at Bloomberg Intelligence.
After exploding into a $7 trillion industry, index funds are facing slower asset growth and declining fee revenue. Profit margins have come down and even the biggest firms have eliminated workers, reducing costs. Shares of publicly traded fund managers are well off their highs a year ago, even after rebounding in recent months. And questions about whether we’ve reached “peak passive” are starting to grow.
The revelation last week that one ambitious (if tiny) fund manager would offer the first negative-fee ETF, in a bid to swell its AUM, would offer the world’s first negative-fee ETF (the firm, Salt Financial, would pay out 50 cents for every $1,000 invested on the first $100 million.
Of course, it doesn’t take a rocket scientist to figure out that, when all of your AUM growth is generated by funds charging 30 basis points or less, margins will inevitably be squeezed.
And as the competition for investor money intensifies, the question is how much lower can asset managers afford to go, and should they?
“If the organic growth is going to stuff that makes no money, that’s where you see those margins coming down,” says Balchunas. “That’s what really scares” shareholders of these fund-management firms.
Of course, while it’s tempting to interpret Salt Financial’s negative-fee fund as a gimmick, it also highlights a legitimate concern about the anti-competitive impact of the race to the bottom (as firms like State Street and BlackRock, thanks to their sheer heft, have a built-in advantage).
“There are anti-competitive hurdles that we’re trying to jump over,” says Alfred Eskandar, president and co-founder of Salt Financial. The Securities and Exchange Commission is planning to engage with small- and mid-sized fund sponsors amid concern fee compression could push them out and limit investor choice, Dalia Blass, who heads the regulator’s investment-management division, said this week.
Eskandar’s Salt and SoFi are gambling that investors stick with them if they start charging fees. In general, issuers can minimize the roughly $200,000 a year it costs to run an ETF by using an in-house index rather than licensing a more popular one. They could also lend out securities for extra income. Yet there are limits when the product itself generates no revenue.
A decade ago, Deutsche Bank’s European asset management unit started a pioneering no-cost stock ETF, but ultimately raised its price five years later. Now, much of the debate is over how sustainable the ultra-low cost model will be when the bull market finally ends.
But setting concerns that the fee battles are distorting markets’ natural supply/demand dynamics, at a certain point, something just has to give.
“It does still cost something to manage the funds and to service the funds and distribute the funds,” says Noel Archard, global head of product for State Street’s ETF business. When it comes to the fee war, “there’s a logical bottoming-out point. We’re getting pretty close to that threshold.”
And with interest rates set to remain lower for longer after Powell triggered another round of yield-curve flattening after the close of the March FOMC meeting on Wednesday, it appears that point is fast approaching.