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  • Writer's pictureJulie Skye

Do You Really Think Investment Firms Make NO MONEY on ETFs?

Today one of my super-smart clients shared this link with me and it all became clear: this is why companies are falling all over themselves to sell you all those "free" ETFs.{%22utm_source%22:%22push%22,%22utm_medium%22:%22notification%22}

Back in February I ran out of patience when talking about all those "0% Fee-ETFs " so I listed the conflicts of interest and the lack of transparency with Morningstar AND ETFs. I didn't expect this ETF Tax Dodge to surface, but it is worse than I expected.

Here is how I sized up all those "free funds."

"Skye Advisors’ focus is on finding the best investment ideas; eliminating conflicts of interest; improving transparency; bringing you time-saving software solutions and reducing every fee possible. When I see pieces I think will be of interest I collect them to send out in ESG Matters or my blog. The first here is “5 Star Funds” from Morningstar and the other is “Fees Fees Fees.” Here is the Wikipedia firm overview of Morningstar and how they make their money.

Morningstar, Inc. is a global financial services firm headquartered in Chicago. It was founded in 1984 and provides a wide array of investment research and investment management services. Morningstar's research and recommendations are considered extremely influential in the asset management industry: a positive or negative recommendation from Morningstar analysts can drive billions of dollars into, or away from, a fund. The firm currently manages $200 billion.

The firm's signature "star" ratings are often used by fund managers in marketing materials, and positive star ratings bring a significant level of credibility to a fund's strategy. Morningstar's analysts and data are frequently quoted in outlets like the New York Times, Wall Street Journal, and Financial Times. In October 2017, the Wall Street Journal published a front-page feature story criticizing Morningstar's influence and questioned the predictive power of the firm's ratings system.

Skye Thoughts - sweet deal but several conflicts of interest. Start a publishing company, rank your competition, build portfolios and charge a fee using those rankings. 35 years later your operating income is $190 million! FACT: I use Morningstar every day, but do NOT simply look for the 5 Star funds with the tallest mountain chart.

The next is what I call “Fees Fees Fees”: ETFs and Index Funds that charge $0…nothing …nada are now on the market. Here is the Wiki overview and some of my issues with them say 0% fees.

Index Fund – From Wikipedia, the free encyclopedia: The main advantage of index funds for investors is they don't require a lot of time to manage as the investors don't have to spend time analyzing various stocks or stock portfolios. Many investors also find it difficult to beat the performance of the S&P 500 Index due to their lack of experience/skill in investing. Dow Jones Indexes has 130,000 indices!

Disadvantages - index funds periodically "re-balance" portfolios to match the underlying securities in the indices. This allows algorithmic traders to do index arbitrage by trading ahead of stock price…making a profit on this knowledge. It is estimated this results in lowered performance of 21 to 28 basis points annually for S&P 500 index funds, and 38 to 77 basis points for Russell 2000 funds. Index funds announce the trades they are planning to make, a legal practice known as "index front running."

John Montgomery of Bridgeway Capital Management says trading ahead of mutual funds is "the elephant in the room" that "shockingly, people are not talking about.” Related "time zone arbitrage" against securities traded overseas is likely "damaging to financial integration between the United States, Asia and Europe.”

Skye Thoughts – So, traders buy low / sell high but don’t have to disclose costs. Companies then make money licensing indices; every fund earns commissions buying or selling what the index fund owns and finally, brokerage firms earn commissions selling the index funds to their clients. These layers of costs reduce performance and I just want them to make it easy to see what those costs are. 50 additional basis points puts index fund expenses on par with other actively managed fund fees!

FACT: firms normally allocate these expenses to each fund: salaries / benefits, administrative expenses, website / technology costs, utilities, rent, taxes, insurance, research / trading and commissions. Index funds just don’t pay these costs. The costs above of running index funds do not show up in the expense ratio. FACT: We do use index funds, but fees are only one if the considerations.

If you have been with me for 20 or 30 years…you already know there is more to investing than buying last year’s tallest Mountain-Chart-Five Star Fund. And YES, fees are hugely important. Trust…assume…know…there is more to building a portfolio than mountains and fees.

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