iShares rattles the core

Will the industry leader's recently announced fee cuts be enough to stem outflows and protect its market share?

John Gabriel 14 April, 2014 | 6:00PM
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The gloves have come off in the ETF price war. After a successful campaign with its low-cost "Core" branded suite of ETFs in the United States, BlackRock iShares last month launched an iShares Core series in Canada. The announcement deserves to be celebrated, not criticized. Regardless, there are going to be those who have qualms over which iShares ETFs made the list and which were left off. Some industry followers might recall that when iShares rolled out its series in the U.S., it was a mix of new product launches and fee reductions on existing ETFs.

For example, rather than slashing the fee on its popular U.S.-listed emerging markets ETF, iShares MSCI Emerging Markets EEM, it launched a similar fund that tracks a broader and deeper index that includes mid- and small-caps. The new fund, iShares Core MSCI Emerging Markets IEMG, was offered at a bargain price of 0.18% per annum, while EEM with its nearly US$50 billion in assets maintained the hefty price tag of 0.69% (today the fund's expense ratio is 0.67%). This may have been a brilliant move with respect to BlackRock's bottom line, but it wasn't the most investor-friendly.

There seems to be a little bit of that going on with the Canadian launch, but I'm not complaining. I applaud iShares for slashing fees on nine of its ETFs. Still, notable omissions from the series include the country's largest ETF, iShares S&P/TSX 60 Index XIU, which has about $13 billion in assets. XIU's management fee remains 0.15% per annum, three times the fee now levied by the broader iShares S&P/TSX Capped Composite Index XIC.

In Canada we have a similar case as the EEM story, but on a smaller scale. A back-of-the-envelope calculation suggests that XIU rakes in about $20 million a year for BlackRock Canada with a 0.15% management fee. If it were to drop XIU's management fee to 0.05%, then XIU "only" grosses about $7 million annually. Rather than taking a $13-million hit, the firm opted to build up XIC. (Note that these numbers are just estimates intended to help illustrate the situation.)

In my opinion, XIC is preferable to XIU for strategic, long-term exposure to Canadian equities anyway, mainly because of its more comprehensive portfolio; it has around 250 holdings compared to XIU's 60. Following its significant fee reduction, XIC is a clear standout in the asset class. Comparable alternatives like Vanguard FTSE Canada All Cap Index VCN and BMO S&P/TSX Capped Composite Index ZCN, which each charge management fees of 0.15%, now appear expensive on a relative basis.

But don't expect a mass exodus from XIU into XIC as a result of the fee cut. XIU is the granddaddy of them all in Canada and isn't likely to be unseated anytime soon. Its unparalleled secondary market liquidity makes it a useful tool for institutional investors looking to make large trades quickly and efficiently, without disrupting the market. It will remain as the institutional tool of choice despite its higher price tag. For retail investors, however, it is hard to justify investing in XIU when XIC is available for one-third of the price and provides exposure to about 95% of the domestic market.

If iShares really is protecting its golden goose by slashing XIC's fee instead of XIU's, how long can the company really get away with it? Has XIU reached such as status that iShares is now able to charge a premium for XIU's liquidity? I would find it hard to believe that institutional investors are paying more for exposure to the Canadian market (and a smaller slice at that) than retail investors.

I have to admit I was a bit surprised that iShares Canadian Universe Bond Index XBB didn't make the list for core exposure to the Canadian bond market. It has been the "go-to" core bond ETF for years and was recently undercut by rivals. With a management fee of 0.30%, XBB charges 50% more than Vanguard Aggregate Bond Index VAB and BMO Aggregate Bond Index ZAG. Considering that it has $1.5 billion in assets, if iShares slashed XBB's fee to, say, 0.10%, then it would have forfeited about $3 million in annual revenue (the difference between the $4.5 million it earns with a 0.30% fee and the $1.5 million it would earn with a 0.10% fee). Instead, it will look to build critical mass in iShares High Quality Canadian Bond Index CAB.

The fund has a new name and a new mandate; it was formerly part of the "advantaged" series, which employed a synthetic swap structure to re-characterize income as capital gains. It changed the mandate in response to proposals set forth in the 2013 Federal Budget that target investment structures that generate returns in the form of capital gains rather than interest income. Given the strategy change, I think investors should approach CAB as if it were a newly launched ETF, and I'm going to reserve judgment until it has a chance to prove its mettle.

Given its new mandate, CAB's past performance is now irrelevant and shouldn't be part of an investor's evaluation process when considering investing there. A notable difference worth pointing out is that CAB offers greater exposure to corporate bonds than its rivals. Its portfolio is comprised of 60% government bonds and 40% corporate bonds. By comparison, VAB and ZAG allocate 20% to 30% to corporate bonds, with the rest being made up of government bonds. Yet, the yields for each of these core bond ETFs look very similar, as CAB's greater exposure to corporate credit is offset by its slightly shorter duration.

In international equities, the story was much the same as it was in the U.S. when the firm first introduced its iShares Core series. Rather than slashing the fees on the older and much larger iShares MSCI EAFE Index (CAD-Hedged) XIN (0.50% MER) and iShares MSCI Emerging Markets Index XEM (0.79% MER), it is offering iShares MSCI EAFE IMI Index XEF and iShares MSCI Emerging Markets IMI Index XEC with management fees of 0.20% and 0.25%, respectively. The "IMI" here stands for "investable market index," which means that these benchmarks cover the entire developed and emerging stock markets all the way down to small caps. These are excellent core funds for strategic long-term exposure, so we're not going to balk about XIN and XEM.

The other ETFs that made the list appear to be funds that iShares would like to promote and increase in scale. The $203-million iShares S&P/TSX Equity Income Index XEI is a curious pick to include on the list, considering that iShares offers two other ETFs with much bigger asset bases. With nearly $1.4 billion in assets, iShares Canadian Select Dividend Index XDV, which charges an MER of 0.55%, is the firm's the largest dividend-themed fund, while iShares S&P/TSX Canadian Dividend Aristocrats Index CDZ has about $1 billion in assets and charges an MER of 0.66%.

Rounding out the list are two more Canadian fixed income ETFs: iShares Canadian Short Term Corporate + Maple Bond Index XSH and iShares Canadian Long Term Bond Index XLB. I would agree that these ETFs don't exactly scream "core." Given their vastly different maturity profiles, their potential use in the core however, could be to adjust the overall duration exposure of the portfolio. XSH sports a weighted average duration of 2.76 years, XLB's duration is 13.46 years, and CAB's is 6.12 years. Therefore the ETFs could be blended together to achieve the desired duration target.

Choosing to highlight XSH instead of a fund like iShares 1-5 Year Laddered Corporate Bond Index CBO is another shrewd business decision. CBO has about $2 billion in assets and charges a management fee of 0.25%, roughly double XSH's new fee. Though CBO has considerably less holdings, its overall duration, credit and yield-to-maturity profiles are nearly identical to those of XSH.

The iShares Core series as a whole is a strong lineup, and my goal in picking apart the list wasn't to cast a dim light on the news. BlackRock is not the first or only fund provider that juggles serving its fundholders and serving its public equity shareholders, and it certainly won't be the last. The optics suggest that the firm made some decisions to protect its profits. In any case, investors still end up better off than they were before. For that iShares deserves praise.

There still seems to be a few spots in its line-up where it can be more competitive on fees. Let's hope the folks at BlackRock Canada make more cuts in the future and keep narrowing the expense gap with our U.S. neighbours. If not, I'm sure Vanguard and BMO wouldn't mind continuing to encroach on its dominant market share.

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John Gabriel

John Gabriel  John Gabriel is a strategist for Morningstar’s manager research team.

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