Why the 'race to zero' doesn't exist
There is much talk these days about the trend toward lower fees as “the race to zero.” Let’s face it, free is probably never going to happen.
That’s because when it comes to investment products, everybody gets paid. If you think you have a free investment product or service, you just haven’t looked hard enough at the fees. And even if you’re not paying a traditional expense, there are still costs associated with using free products and services.
We are starting to see the emergence of no-cost or low-cost portfolios offered through platforms and robo advisors. In addition to any stated portfolio strategist fee, the costs associated with these portfolios can come in two forms.
First are the internal expense ratios of the funds themselves. Many large fund companies now offer free portfolios that use their own funds and ETFs as the building blocks. Clients may not pay a traditional portfolio strategist fee, but the fund companies make money through the fund management fees. The internal expenses in these portfolios vary widely making some of these portfolios cheaper than others.
Another variety is being offered by portfolio strategists that do not have their own proprietary products. These firms have made arrangements with a limited number of fund companies to use their products exclusively. The providers pay the strategist firms to use their funds by sharing a portion of the funds’ internal expenses.
Pay attention to the level of these expenses in particular — they must be high enough to pay the strategists.
The other type of cost is much harder to quantify. It comes as a consequence of using a limited universe of funds and ETFs in the construction of free or low-cost portfolios. The fund companies and strategists mentioned above, of course, use a very limited selection of building blocks. Even robo advisors have strict limits on the products they use.
When a portfolio manager restricts the products it can use, it loses access to the broader universe of funds and ETFs that might make the portfolio more competitive. The lost opportunity cost caused by these restrictions is impossible to calculate, but it's unavoidable without a truly open architecture approach to fund selection.
This does not mean that free portfolios are bad portfolios. Many of the firms offering free portfolios are excellent investment management organizations. We use some of their products in the construction of portfolios at our firm. But no investment management firm has a monopoly on the best products. Check the Morningstar database if you need proof.
Restricting the available building blocks to those of one, or even a few, providers would not matter so much if the funds were interchangeable, but they are not. Advisors can readily see the differences in actively managed funds.
The differences appear in internal expenses, investment processes, the skill of their managers, and ultimately performance. But even plain vanilla ETFs vary in terms of their expenses, liquidity, and performance. There can be wide dispersion among both actively managed funds and ETFs in the same categories.
This underscores the importance of due diligence when it comes to building or selecting a portfolio for your clients. The fact that a portfolio is available without a traditional strategist fee, or is available at a low cost does not relieve you of your fiduciary duties.
All things being equal, lower fees are better for clients. But there are many other relevant factors to consider. You can only determine if a “free” portfolio is appropriate for your clients after a thorough review of the portfolio, its components, and other available alternatives.