BlackRock, the large investment company based in New York, recently slashed prices for many of their passive index offerings in late 2016. Schwab and Fidelity followed along and reduced prices for many of their passive index funds. Others are also following the same path. Of course, all this fee reduction is good for the end investor. And certainly we would recommend to our clients that they ask about these fee changes. However, there are other considerations to think about when selecting passive index options for your investment menu.
To be clear, we always recommend our plan sponsors be thoughtful about their selection of passive index funds to put on the investment menu; and this analysis should include fees. However, the magnitude of these fee changes impacts the participant less than one would think. Take, for example, a fund going from 12 bps to 10 bps in expense ratio. For a participant with $10,000 in this particular product, their annual fee goes from $12 to $10. Now, depending on how many zeroes a participant has more or less around that example, the magnitude of the fee change is greater or less in dollar terms. However, the extra dollars in the participant’s pockets could be easily wiped away by other factors.
Many passive index strategies are easy to replicate. The fund manager simply buys these liquid securities in the appropriate amounts and rebalances the portfolio on occasion to keep it all balanced relative to the benchmark index. However, there are other investment strategies in which replication is more difficult. Take the example of fixed income. Unlike in a typical passive large cap index strategy where the portfolio manager can readily go out to the market to purchase or sell shares of highly liquid securities, a portfolio manager of a passive fixed income strategy does not always have the same luxury. This is especially true when it comes to matching exposures of less liquid securities such as high yield, securitized products, emerging market debt, among other sectors. Or take the example of small caps, the portfolio managers again face the difficulty of finding securities liquid enough to replicate the index. For both examples, the portfolio manager must go beyond simply buying the exact security in the exact amount. Instead, they may need to replicate the exposure. For example, instead of buying Apple at the exact percentage, the portfolio manager may need to purchase a basket of stocks that in sum may act like Apple. Imagine doing this for even less liquid securities such as a pool of securitized agency mortgages. The issue of liquidity is one of numerous portfolio management issues in building a passive index strategy. This issue can become difficult to manage especially during high volatility periods such as The Great Financial Crisis, when securities become more volatile and the cost of illiquidity rises.
Besides the portfolio management issues, plan sponsors also need to work within the constraints or offerings of their vendor. In order to access these products with reduced fees, the investment minimum may often be too high for a particular plan. In other cases, the product may not be available on the platform offered by your recordkeeper.
Although the recent fee wars are a welcomed competition between investment management firms, please be mindful of the dollars you could lose in trying to save pennies by not considering other factors in selecting a passive index fund.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.