What should investors do when their exchange-traded fund changes course in midstream?
Competition for your investment dollars is pushing a growing number of ETF providers to tinker with their underlying indexes and, in some cases, their fees.
While fee cuts even temporary ones are welcome, a change to the index on which an ETF is based can throw unsuspecting investors for a loop.
In late October, State Street Global Advisors changed the index provider for five of its financial ETFs to Standard and Poor's from Keefe, Bruyette and Woods. The two index methodologies differ significantly: Standard & Poor's bank indexes weight companies equally, whereas the indexes from KBW weight them by market capitalization.
The change prompted State Street's $1.1 billion SPDR S&P Bank (KBE)
In response, Invesco (IVZ)
Similarly, on Thursday, Russell Investments cut fees on its 13 volatility, beta and momentum ETFs after several competitors including Direxion this past week recently launched or announced similar products.
Look Before Switching
What does all this fee-slashing mean for investors? It's a sign that ETF managers are more than willing to make concessions to keep you in their funds or, conversely, entice you to try something new when competing ETFs and indexes arise.
Still, investors shouldn't switch in response to a fee cut alone, advisers say. "It's not enough incentive to switch if you prefer the new index," says Michael Johnston, senior analyst for publisher ETF Database.
The State Street index change, which was approved by the funds' board in August, has been well received so far, says Scott Ebner, global head of product development at State Street Global Advisors. He says investors are looking at total cost of ownership, going beyond expense ratios to consider liquidity, bid/ask spreads and commissions.
All this movement is just the latest response to massive growth and competition in ETFs. Over the last decade, ETF assets have grown to more than $1 trillion, mostly in the form of index funds tracking the S&P 500, Nasdaq 100, Russell 2000 and various international indexes from MSCI (MSCI)
Thanks to their structure, ETFs allow managers to maximize capital losses and minimize capital gains when they make significant portfolio changes, thereby limiting tax consequences for the fund. But if an investor in such a fund chooses to sell, he could face short-term or long-term gains on their own shares and a potential tax bill.
According to data from publisher IndexUniverse, 77 ETFs have swapped their indexes since January 2010. Of those changes, 44 were deemed substantial based on shifts in components or weighting most notably two moves by Guggenheim Funds that resulted in wholesale transformations to two ETFs.
Even investors in some of the oldest exchange-traded products are about to get a similar wholesale shock. Van Eck Global is in the process of taking over six HOLDRs, offered by Merrill Lynch more than a decade ago, including the $1.7 billion Oil Services HOLDR (OIH)
Van Eck has created new Market Vectors ETFs and indexes for the HOLDRs, but the shift won't be without holding and tax consequences. Due to HOLDRs' structure, capital gains or losses for the stocks leaving the portfolio will be pushed out to investors, based on their original purchase price.
The last significant gambit around indexes and fees was played by Old Mutual, which launched an emerging-market ETF in 2009 with a temporary 0% expense ratio, to compete against Vanguard Group and BlackRock (BLK)'s
While current ETF providers may have more stamina, they may have to offer more than just temporary fee cuts for their products to stand out. According to IndexUniverse, of the more than 1,300 exchange-traded products in the U.S., 80% of the assets are controlled by just 101 funds.