ETF Fee-Pricing Model Based On Index Strategy

I created an ETF pricing model based on the information from the Index Strategy Box fee data. The purpose of the model is to benchmark ETF fees to the complexity of each underlying index strategy. Investors have been conditioned to pay higher fees for ETFs that follow alpha-seeking strategy indexes. However, until now there has been no model for relating different indexing strategies to ETF fees. The model is a guide to average strategy pricing. No assumptions are made as to whether any particular index strategy is worth the average fee charged by ETF companies to follow that strategy.

There are two uses for an ETF pricing model based on index strategy. First, investors can compare the fees of ETFs using like indexing strategies. Second, ETF companies can use the data to price new ETFs in line with the competition, and possibly reprice existing ETFs to align them with the average.

Some adjustments needed to be made to the raw fee data to smooth out inconsistencies. Those issues existed mainly from the pricing of security weighting methods; for instance, an adjustment for ETFs following fixed weight methods because of the large number of higher-cost quantitative funds that use a fixed security weighting method. Also, certain index methods commanded higher-than-normal fees even though their strategy is similar to indexes by other vendors. For example, ETFs following fundamentally weighted RAFI indexes were considerably more expensive than ETFs following other fundamentally weighted indexes such as WisdomTree products. Once these adjustments are made, it was possible to create the Index Strategy Box pricing template in Figure 4.

Figure 4 represents additional fees added to the average fee for beta-seeking ETFs in a particular category. Recall that beta-seeking indexes use passive security selection and capitalization weighting. As an example, the iShares S&P 100 Index (AMEX: OEF) charges a fee of 0.20 percent. If an ETF were created that tracked an equal-weighted S&P 100 Index, a reasonable fee would be 0.35 percent. That is the sum of a 0.20 percent market index strategy plus an extra 0.15 percent fixed-weight strategy fee.

I checked the pricing against different index styles to test for consistency of Index Strategy Boxes fees across nonoverlapping sets of data. The three styles I tested were 1) broad market and large-cap ETFs, 2) mid-cap and small-cap ETFs, and 3) industry sector indexes. The fees charged by ETFs in the three different data sets were remarkably consistent with the pricing template in Figure 4.

An Example Of Fee Pricing With Index Strategy Boxes

The Index Strategy Box fee pricing template is a valuable tool that can be used by investors, advisors and ETF providers. The following is an example of how this pricing model can be applied.

I analyzed the fees in the U.S. broad market and large-cap sectors from the ETFguide.com database. The average ETF fee for beta exposure in this category is 0.20 percent. Once the cost of beta was known, I applied the Index Strategy Box pricing template to the 0.20 percent fee. The results are illustrated in Figure 5.

Investors and advisors can refer to the data in Figure 5 to determine fair fees for each ETF that follows a particular index strategy. For example, assume an advisor is considering the purchase of a U.S. large-cap growth ETF. The cost for one ETF under consideration is 0.35 percent, while the cost for another is 0.60 percent. Which ETF is more or less overpriced than the other?

The answer is that it depends on the underlying index strategy of each fund. If the 0.35 percent ETF is a passively selected and capitalization-weighted “Beta” fund, and the 0.60% ETF follows an alpha-seeking index that uses a quantitatively driven index and weights stocks using fixed weights, then based on index strategy alone, the 0.60 percent fund is a better value than the 0.35 percent fund.



I am NOT suggesting that investors should buy the 0.60 percent quantitative ETF. Rather, I am suggesting that the 0.35 percent beta ETF is overpriced.

Summary

There is a clear link between the complexity of index strategy and the fees ETF companies charge for products. It is important for investors and advisors to understand this relationship when analyzing competing products.

The Index Strategy Box Pricing Template for ETFs is one tool that can be used to compare the pricing of any category of funds. The methodology should assist investors with ETF comparisons and guide product providers to create a more uniform pricing model.

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