Would you pay $1,000 for the original iPhone?
Of course you wouldn't. But that's basically what some institutional investors do all the time when they use exchange traded funds—and why retail investors may be ahead of the curve.
Nowhere is this on greater display than in the emerging markets. After spending half a decade in the performance doghouse, broad emerging markets indexes have risen steadily this year and are up about 6 percent as of April 27.
Of the $4 billion that has flowed into emerging markets so far this year, more than $3 billion has gone into the iShares MSCI Emerging Markets ETF (EEM). This is by far the most expensive of the big emerging markets ETFs, as shown in the chart below. This is a case of “smart” money not acting so smart ("hot" money is probably a better moniker).
EEM was a game-changing product when it came out 13 years ago. But many cheaper, better designed, and increasingly liquid emerging market ETFs have arrived since then—including one from iShares itself. As with any industry, innovation and lower cost are part of the evolution of products. A lot of the hot money seems to be blind to that.
The cost difference between EEM and some of its peers is stark. Normally, the most-traded ETF costs a few basis points more. EEM, however, is almost four times more expensive than most of its peers.
The ETF can get away with that because highly traded ETFs are often darlings of a large universe of traders, who typically have shorter holding periods and larger trade sizes. The level of fees isn't a big consideration. So when highly traded ETFs see big inflows over a short period, it’s safe to assume the money is institutional. Hedge funds currently own more than 11 percent of EEM, according to Bloomberg data. The top holder: Bridgewater Associates, with 5.5 percent.
EEM is also the worst of the bunch at tracking its index, which is an ETF's sole purpose in life. That's because of its high expense ratio of 0.69 percent, which gets subtracted from returns.
This is why, for institutional investors, buying EEM is a bit like paying $1,000 for that original iPhone.
How do we know institutional money is piling into EEM? With ETFs, institutions are typically the ones chasing performance. And institutional money usually flocks to the most-traded ETF in a category.
EEM’s $2 billion a day in volume makes many institutional investors drool. BlackRock Inc. knows that, which is why it doesn't lower fees on EEM even as Vanguard Group and Charles Schwab Corp. wage a fee war. So while EEM may be the 18th largest ETF by assets, with $26 billion, it ranks third in revenue generation. It pulls in about $175 million a year, as shown in the table below.
BlackRock hasn't just ignored the fee war. It has raised EEM’s fee—a practically unheard move for an ETF. EEM used to charge 0.67 percent. Now it charges 0.69 percent—a rare case when a popular ETF charges more than (gasp) the average active mutual fund.
Retail money, meanwhile, has been doing its typical slow, steady trickle into newer, cheaper emerging market ETFs over the past five years. That's arguably the smarter move, since those investors are buying in at lower prices and paying lower fees.
So while institutions continue to be blinded by ETF exchange volume, retail investors shouldn't be fooled. Popularity doesn't always equal smart.
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