ETFs have long been a low-cost way to invest, but when it comes to just how low, the devil is in the details. That's because with some of the ETFs on the market the only way to maintain the low initial cost is through an expense waiver.
Expense Waivers Help Funds Compete
Common in the ETF world, funds will offer rock bottom expense ratios, but there's a catch. Buried in the ETF prospectus is an expiration on the low expense ratio. Basically, the investor gets a discount for a set period and then the expense ratio resets at a higher amount. The teaser rate may last for say a year, requiring the waiver to be renewed. Many ETFs renew the waiver automatically, but there are some that do not.
Reasons for offering a waiver vary but the biggest one is simply for marketing purposes. With investors increasingly seeking low cost, passive ways to invest there's been an explosion in the number of ETFs. According to the Investment Company Institute, as of December of 2014, there were 1,411 ETFs domiciled in the U.S. with total net assets of $1.974 trillion. While all these different ETFs compete based on investment type, a big factor for investors when choosing a ETF is the expense ratio. The lower that is, the more popular the fund is likely to be. (Read more, here: How ETF Fees Work.)
ETF Low Expense Ratios Can Reset
Large ETFs that have been around for a while don't have to go to great lengths to get investor interest, but startups do and know investors care about the expense ratio. Because of that, competing funds will offer these too good to be true expense ratios with a catch: it doesn't last forever.
Earlier this month CNBC highlighted the expense waiver with some ETFs, pointing to Goldman Sachs' new Smart beta ETFs. Goldman Sachs can offer the ETFs for rock bottom prices and according to the report, Goldman Sachs was able to provide a low expense ratio because of its expense waiver. According to CNBC, a Goldman Sachs spokesman said the investment firm is replacing the fee waivers on its smart beta ETFs with permanent rates that were the same as the under the waivers. CNBC noted that based on Morningstar data there are 549 ETFs that have an expense waiver that needs to be renewed each year. Another example pointed to in a recent Barron’s article: The iShares Treasury Floating Rate Bond ETF, which came on the scene in 2014. According to Barron’s the management fee was zero, but it only lasted two years before changing to 0.15%. There's also a practical reason why some fund companies include expense waivers with their ETFs. Raising the fees on an ETF isn't something easily done, but a waiver gives it the flexibility to potentially raise the expense ratio without all the red tape.
(Read more, here: ETFs Vs. Index Funds: Quantifying The Difference.)
Investors Have To Read The ETF Prospectus
Expense waivers in and of themselves aren’t evil, but investors shopping for ETFs need to know how long an expense ratio will last, even if it remains low. Take the iShares Treasury Floating Rate Bond ETF. While there was no management fee from the start, once the waiver expired the fee went to 0.15%, which is lower than a lot of other investments on the market. Still, investors should look through the ETF fund prospectus to ensure they aren’t getting a teaser rate or if they are they know what it will reset to. In the case of the waiver, investors need to pay close attention to the fees and expenses section of the ETF prospectus. There investors will find a breakdown of the fees and where they are going to. They will also get a hypothetical example of what the fund will cost over different periods whether that’s one, three, five or ten years. (Read more, here: Pay Attention To Your Fund’s Expense Ratio.)
The Bottom Line
With ETFs growing in popularity fund managers are rolling out funds with rock-bottom expense ratios to lure investors in. But buyer beware. That low cost may not last forever, which is why investors have to read the fine print in the prospectus before purchasing an ETF.