VOO Doo!? ETFs Become More Efficient

Last week Vanguard launched VOO, their S&P 500 ETF to compete with iShares’ IVV and State Street’s SPY. Together these two ETFs contain around $94 billion and represent more than 10% of the ETF industry’s total assets. Whether Vanguard can gain traction with VOO remains to be seen as many other second and third to market ETFs have failed to achieve much success in the ETF marketplace. Regardless, 2010 may take its place in history as the year ETFs became even more efficient in terms of access (commissions) and ongoing cost of ownership (expense ratios).

Vanguard has a wealth of momentum lately. They have received around half the ETF industry’s inflows through the end of August and recently were named number one in financial advisor loyalty in the ETF space. Now Vanguard will offer the S&P 500 at a 6bps expense ratio versus 9bps for the competition. Oh, and did I mention that Vanguard clients can also trade VOO commission free? VOO definitely has a lot of factors in its favor and should gather enough assets — probably billions — to be a profitable product for Vanguard. Whether it takes material market share from IVV or SPY is another matter. My guess is that VOO will not be able to significantly impact either ETFs’ asset base in the next few years. First SPY and IVV have a tremendous amount of volume — or perceived liquidity — that will continue to attract the trading crowd. Second SPY and IVV are likely to reduce expense ratios if VOO builds too much traction. In fact it will be interesting to see who reduces their expense ratio first — iShares or State Street? Remember iShares just reduced IAU (Gold) from 40bps to 25bps to undercut State Street’s GLD which remains at 40bps. (almost a 40% expense ratio difference!) Will State Street counterpunch with a lower SPY expense ratio before iShares lands another blow? I don’t think so! I think State Street will get beat again by iShares to reduce fees. Why? State Street stands to lose more absolute revenue than iShares due to the difference in AUM between the funds. iShares has about $22 billion in IVV versus $72 billion in SPY for State Street. That’s a big revenue hit that State Street would likely try to avoid given the reduction in revenue would be about 33%! Ouch…

From a macro view, being the sponsor of a broad based ETF in the market has become a bit unnerving. As firms with retail distribution and commission free trading muscle into sponsoring ETFs, they are able to put even more downward pressure on fees. Suddenly, large broad based ETFs like iShares Russell 3000 (IWV, $14bil, 21bps), Dow Diamonds (DIA, $8.5bil, 17bps), and the Powershares QQQ (QQQQ, $18bil, 20bps) look grossly overpriced and ripe for the picking. 20bps for a 100 stock NASDAQ ETF, when the S&P 500 ETF is 6bps? Really? Outside of licensing protections, it doesn’t seem like those lofty expense ratios will last for long, which is great for investors and will make ETFs even more attractive.

In the months to come it will be interesting to see which ETF products are targeted next. Bets, anyone?