Fee Wars: Why Do iShares Sector ETFs Cost So Much?

The current fee battle between exchange-traded fund (ETF) companies took an odd twist this week with the launch of 10 new Fidelity sector ETFs.

The headline story was that Fidelity's MSCI linked sector ETFs are "nearly 80% below the industry average for passive sector ETFs" and even cheaper by two basis points (0.02%) compared to their rival Vanguard's MSCI sector ETFs.

The other story line is that Fidelity hired BlackRock as sub-adviser for its 10 passive sector ETFs, "leveraging the firm's passive investment management capabilities and scale."

And here's where the story's plot thickens: BlackRock also manages its own sector ETFs under the iShares brand, which begs the question; How does BlackRock justify charging fees on its iShares sector funds that are almost four times more expensive versus the 0.12% fee it receives for sub-advising Fidelity MSCI sector ETFs?

The 31 U.S. sector ETFs offered by BlackRock's iShares have average expense ratios of 0.45%. The bulk of these iShares sector ETFs (27) track Dow Jones Sector indices and charge 0.45% annually. The others, like the iShares Nasdaq Biotechnology ETF (NASDAQGIDS:IBB), iShares Real Estate 50 (NYSEARCA:FTY), and iShares PHLX SOX Semiconductor ETF (NASDAQGIDS:SOXX) are linked to non-Dow Jones indices and charge slightly higher expenses of 0.48%. Among the group, the iShares Cohen & Steers REIT ETF (NYSEARCA:ICF) charges the lowest expense ratio of just 0.35%.

Occasionally, there can be significant discrepancies between the cost of ETFs in the same investment categories, as the iShares U.S. sector ETFs illustrate. But for the most part, the fees charged by ETF providers are still tame compared to the infinitively bad alternatives elsewhere.

For instance, compared to the mutual fund and hedge fund industry's bloated fee structures, the expense ratios in the ETF industry are a bargain. The average expense ratio for international stock mutual funds (NASDAQ:PRITX) is 1.57% whereas it's just 0.56% with international stock ETFs, according to FINRA's fund analyzer tool. That's a 64% cost difference and enormous potential savings for investors that choose ETFs!

Still, the prudent investor - even with ETFs - should take deliberate steps to make sure they aren't paying more than absolutely necessary.

In certain cases, it might make sense to pay a slightly higher fee (but one that's still in the same general ballpark as its peers) for market exposure that isn't available elsewhere.

For instance, the Select Sector SPDRs follow each of the nine industry sectors within the S&P 500 (NYSEARCA:VOO) and charge a modest annual expense ratio of 0.18%. If you want exposure to specific S&P 500 stocks within a certain sector, say energy (NYSEARCA:XLE) or technology (NYSEARCA:XLK), the Sector SPDRs are your only choice, and a pretty good one at that.

Getting back to the original question: Why do iShares sector ETFs cost so much? There could be a myriad of reasons.

Maybe it's because BlackRock is stuck in a bad contract with SPDR Dow Jones Indices that forces them to pay substantially higher sector index licensing fees and they're merely passing on those higher costs to investors. Or, maybe it's because aggressive fee cuts aren't a corporate priority.

Whatever the reason, there's a valuable lesson for all of us. Buying ETFs with fees that are meaningfully higher versus their peer group, whether they are sector funds, bond funds, or something else, is usually a bad deal.

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