The costs of exchange-traded funds (ETFs) have been moving lower recently. However, as these expenses decline, many fund providers are taking creative approaches to make up for lost revenue. Investors considering ETFs can benefit from learning more about the fees involved, as these expenses can have a significant impact on returns.

Expense Ratio

Being familiar with the expense ratio, which is the annual fee that funds charge their investors, is crucial to understanding ETF costs. This ratio measures the expenses associated with operating the fund as a percentage of total assets. A fund’s operating expenses could potentially include management fees, administrative fees, 12b-1 fees and legal expenses.

The operating expenses associated with different funds cover a wide range, and funds calculate their expense ratios annually. Any expenses taken out for a fund’s operation will lower that fund’s returns. This distinction is crucial, as final returns might be a key variable in fund selection. In fact, Morningstar, Inc. (NASDAQ: MORN) has stated that expense ratios are still the most dependable predictor of performance, and investors should use these ratios as a primary test when considering funds. In addition, Morningstar emphasized that an easy way to increase the odds of success is purchasing funds with low fees.

Gradual Decline in Fees

While fees are grabbing significant attention, there is evidence that they have been declining. In November 2015, BlackRock, Inc. (NYSE: BLK), which at the time had $818 billion in U.S. ETF assets under management (AUM), announced it was trimming fees on seven of its iShares Core ETFs. As a result of this move, the iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA: ITOT) became the cheapest such fund, after BlackRock cut its expense ratio from 0.07% to 0.03%.

BlackRock’s competitors quickly followed suit, as Charles Schwab Corp. (NYSE: SCHW) responded by matching this reduction, and Vanguard Group declared it would lower fees by up to 25% on dozens of its funds. Amid these developments, Morningstar estimated that the number of ETFs and mutual funds that cost less than $10 per $10,000 invested has surpassed 100. Some of the funds whose expenses have declined the most are ETFs that attempt to replicate broad indexes.

Industry Response

As industry fees push lower, some companies have been marketing alternative ETFs, investment vehicles that leverage unconventional strategies to help investors obtain exposure to strategies they could not otherwise access. The funds grant investors access to volatility-based strategies, hedge fund strategies, and other strategies that use leverage, currency hedging and options to modify stock and bond exposure.

While these funds may provide investors with a wealth of options, they frequently have higher expenses. For example, the Global X SuperDividend Alternatives ETF (NASDAQ: ALTY) provides investors with broad exposure to income-generating assets, including master limited partnerships (MLPs), infrastructure and real estate, as well as fixed-income and derivative strategies, by following the Indxx SuperDividend Alternatives Index. While ALTY provides robust income, offering a 30-day SEC yield of 9.03% as of April 1, 2016, it also comes with high expenses, including an annual fund operating expense of 1.4% and total expenses of 3.03%.

Active Funds' Rising Fees

The expenses of passively managed funds have tracked lower in recent years, but the costs of actively managed funds have gone in the opposite direction. For example, alternative mutual funds had an average expense ratio of 1.48% in 1990, but that ratio had risen to 1.89% by March 2016.

Since many alternative ETFs are new, they may not have had to build up the same levels of assets as more established funds such as Standard & Poor's depositary receipts. This smaller asset base may place upward pressure on the expenses of these smaller funds. Should these alternative ETFs grow more popular, it may be easier for them to reduce their fees. At any rate, investors should keep in mind the key role that expenses have on fund returns. These costs can be the difference between meeting or missing one’s investment objectives.

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