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Morningstar Publishes Research to Help Investors Assess the True Cost of European Strategic-Beta ETFs

Morningstar UK Limited, a subsidiary of Morningstar, Inc. (NASDAQ: MORN), a leading provider of independent investment research, today published a research report, “Assessing the True Cost of Strategic-Beta ETFs.”

Authored by Morningstar’s Passive Funds Research team, the report examines the differences in costs between strategic-beta exchange-traded funds (ETFs) and their more ordinary passive peers. The study assesses differences in fees, replication costs, and trading costs for 100 European-domiciled strategic-beta ETFs and 77 market-cap-weighted ETFs linked to some of the most widely used broad equity benchmarks.

Morningstar defines strategic beta as a class of index-tracking investment products that seek to either improve performance or alter the level of risk relative to a standard benchmark. Strategic beta represents a fast-growing middle ground on the active-to-passive investment spectrum. As at 31 December 2015, there were 950 strategic-beta exchange-traded products representing approximately US$478 billion in assets worldwide.

“Investors in strategic-beta ETFs, like those investing in actively managed funds, are more concerned with performance and the intricacies of a specific strategy than they are with cost,” Hortense Bioy, CFA, Morningstar’s Director of European Passive Funds Research, said. “While this is understandable, they should keep in mind that there is a wide disparity in the fees charged by strategic-beta funds, even by those offering exposure to similar strategies, and that low-cost funds have greater odds of future success.”

Key findings of the research report include:

  • Strategic-beta ETFs are, on average, more expensive than their market-cap-weighted counterparts. ETFs in the U.S. large-cap category are the most expensive, in relative terms. The average total expense ratio (TER) of strategic-beta ETFs using the S&P 500 as a parent index is three times higher than that of ordinary S&P 500 ETFs (0.43 percent versus 0.14 percent)
  • Conversely, the average fee for emerging markets strategic-beta ETFs is only slightly more than that of their market-cap-weighted counterparts (0.60 percent versus 0.53 percent)
  • The average TER in the European strategic-beta ETF space has dropped to 0.39 percent from 0.43 percent over the last five years, primarily because of the introduction of less-expensive strategic-beta products in the market.
  • The higher turnover of holdings in strategic-beta indexes compared to more traditional market-cap-weighted indexes results in relatively higher replication costs, which are not included in a fund’s TER and represent an additional drag on the performance of both physical and synthetic funds. Strategic-beta indexes experience turnover usually ranging from 20 to 30 percent per year whilst average turnover rates for standard market-cap-weighted indexes are between 3 and 8 percent.
  • Investors in strategic-beta ETFs may also face potentially higher trading costs. As many strategic-beta ETFs are relatively new, small, and often used as buy-and-hold-investments, they may have low trading volume and wider bid-ask spreads, thereby increasing trading costs.