Making $22 Million the Easy Way

How would you like to make $22 million? No matter how wealthy you may be, that’s a nice amount of money.

Better yet … how about making $22 million with no extra work? Seriously — it’s free cash for labor you’re already doing.

Your answer is probably something like “Where do I sign up, Ron?” Today I’ll tell you how a company every investor knows made that much (and more) just last year. First, let me give you some background …

Pennies Add Up
In the ETF Business

You know I love ETFs. One reason is their relatively low fees compared to traditional mutual funds. “Relatively low” is not the same as “zero,” however. 

Money management is lucrative because it is scalable. Managing $1 billion isn’t ten times as expensive as managing $100 million. But it can bring the manager ten times more revenue.

Pennies add up in the ETF business.

Fund fees are usually expressed in annualized “basis points.” Each basis point is 0.01 percent, which looks like a tiny amount. But do the math: $1 billion times 0.01 percent is $100,000. That’s more than most households make in a year!

So if you are managing $100 billion, a fee difference of two or three basis points can quickly add up to millions. And thanks to the economies of scale, the lion’s share of it will be pure profit.

Every Player Gets Paid

As I explained in a column last year, “You’re the Winner in the ETF Price War,” ETFs have both internal and external costs. ETF expenses tend to be lower than actively-managed funds because most follow an index. They don’t need to pay for stock-picking.

What investors often forget is that indexes aren’t free. They belong to an index provider, who gets paid by the ETF. And this brings us to that $22 million easy-money deal I mentioned above.

The largest, most actively-traded ETF was also the first U.S. ETF: SPDR S&P 500 (SPY), based on the Standard and Poor’s 500 Index. According to its prospectus, SPY pays S&P an annual licensing fee of $600,000 plus 3 basis points on the ETF’s assets. This added up to $21.9 million for the year ended September 30, 2010, and it’s on course to rack up even more this year.

This is a great deal for S&P! They created the index way back in 1957. They still have to calculate and maintain it, of course, but that’s fairly simple. What do SPY investors get in exchange for their $21.9 million? Answer: The same list of stocks that is freely available to everyone.

Being the inventor of a popular index is like winning the lottery every year!

Now dig a little deeper. SPY’s total operating expenses in that year were $79.2 million. That means about 28 percent of the fees paid by SPY investors went to S&P … which did practically nothing but cash the check!

Don’t get me wrong — I think S&P has a right to make money from its proprietary knowledge. But I would also argue that most SPY shareholders don’t know how much “their” ETF is paying its index provider. The numbers are buried in fine print. And the 28 percent figure isn’t there at all unless you can do the math.

This means that even at what seem like rock-bottom fee structures, the ETF business is immensely profitable for sponsors and other service providers. And that’s why we’ve had a flood of new ETFs the last few years. Others want a piece of the action.

BlackRock: Bringing the
Index Action Home

If creating an index is so simple, why don’t ETF sponsors just do it themselves? Good question. The answer is that the SEC likes the idea of keeping the index provider separate from the fund sponsor. They think it helps avoid conflicts of interest.

The regulators have a point. But is avoiding a potential problem worth sending $22 million out the door every year? BlackRock (BLK) — the world’s largest money manager — doesn’t seem to think so.

Last week, BlackRock filed a request with the SEC to let its iShares ETF family follow in-house indexes instead of those run by third parties like S&P. 

The SEC has granted similar requests to other firms, notably WisdomTree and Russell Investments. But BlackRock wants to go even further and handle all indexing functions internally.

So if the SEC says “Yes,” will BlackRock reduce its fees to reflect the savings? I doubt it. Their goal is to help their own bottom line. Any benefit for ETF shareholders is an added bonus.

In this regard, the ETF industry is following the same path as countless other sectors. Big companies grow by cutting out intermediaries. In theory, the competition helps consumers get a better deal. Time will tell what happens in this case.

Meanwhile, I’m grateful for the innovation of ETF and ETN providers. We have a wealth of choices — and that’s a win for everyone. 

Best wishes,

Ron

P.S. To sort through all those choices, you may want an expert on your side, someone who has been ranked by HULBERT #1 or #2 for cumulative performance among all the ETF and fund analysts Hulbert has tracked — year after year for FIFTEEN years. For the full story, click here to read this report on my International ETF Trader service.