Why Are the Fees for the New Fool 100 ETF Higher Than for Other Index Funds?

In this Rule Breaker Investing podcast, David Gardner brought in some special guests to help him respond to his listeners' questions. And because a few of them are about the Fool 100 ETF, one of those guests is Motley Fool Asset Management Chief Investment Officer Bryan Hinmon.

In this segment, they explain why it is that the fund's fees -- 50 basis points -- are by necessity a little higher. The short answer, in two words: active management. They also discuss what a fund that's focused on smaller stocks -- like the Motley Fool Small-Mid Cap Growth Fund, for example -- does when one of its winning holdings outgrows that range.

A full transcript follows the video.

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This video was recorded on Feb. 28, 2018.

David Gardner: He always brings a disclaimer with him, and I'm assuming Bryan Hinmon of Fool Funds fame will be doing so, today. Last time we had some polka music played to the longest disclaimer ever read on air. Bryan, I know it's not going to be as long this time, but I wanted to have you back because (a) you did a great job last time and (b) I've got two questions for you from Rule Breaker Investing listeners.

Bryan Hinmon: It's a pleasure, and I can't wait.

Gardner: Thank you. Would you like to say something first?

Hinmon: Thanks so much. "My appearance today reflects my personal beliefs, not those of my employer, Motley Fool Asset Management. Motley Fool Asset Management is a separate sister company of The Motley Fool, LLC. Motley Fool Asset Management launched the Fool 100 exchange traded fund and its inception date is Jan. 30, 2018. In addition to normal risks associated with investing in equity securities, investments in the fund are subject to those risks specific to ETFs. Unlike other funds managed by MFAM, the fund is not actively managed, and we do not attempt to take defensive positions in any market conditions, including adverse markets. Likewise, we would not sell shares due to current or projected underperformance of a security, industry, or sector unless that security is removed from the index or the selling of the shares of that security is otherwise required upon a reconstitution of the index. As with all index funds, the performance of the fund and its index may differ from each other for a variety of reasons, including the operating expenses of the portfolio -- transaction costs not incurred by the index. In addition, the fund may not be fully invested in the securities of the index at all times or may hold securities not included in the index. Finally, fund shares may trade at a material discount to NAV, and the risk is heightened in times of market volatility or periods of steep market declines. For more information on the Fool 100 ETF, please visit Fool100ETF.com."

Gardner: Thank you, Bryan! Well done. Love it. You've got your laptop in hand. You kind of bring it up to your nose, almost, and just jam through those words as quickly; but, they're meaningful. They're important. We need to do that, so you did that very well once again. Thank you, sir!

So, two questions for you. The first one comes from my friend Ahmed Awami. Ahmed writes, "Also loved the release of Fool's ETF," which we've also talked about a little bit this podcast, "but I was disappointed by its expense ratio. 50 basis points is kind of high in its category of U.S. large-cap blend." Now, just to make sure we're defining our terms -- because not everybody knows what an expense ratio is -- Bryan, what is an expense ratio?

Hinmon: An expense ratio is the cost of managing the investment product, and so it includes a management fee and it includes, maybe any distribution costs or costs that we pay to third parties to help manage the assets in the fund.

Gardner: Great. And ultimately, it's how we get paid, right? So, if Ahmed buys some of the fund, then we get -- he said 50 basis points. I'm not even sure if that is the exact number. You can say in a sec.

Hinmon: Yes, that is the number -- 50 basis points.

Gardner: OK, good. So that means 0.5% each year you're paying us and, of course, we're not getting all of that, unfortunately. We'd be a better, stronger company if we were, Bryan, but yes, we are paying others to make that possible.

Some people are used to ETFs that are 20 basis points. Maybe even 17 basis points or something like that. There are probably very few ETFs that would ever be 100 basis points. I'm not really sure of the world at large. Bryan, explain a little bit about the 50 basis points and how you think about that.

Hinmon: I'll give you a little bit of context. Ahmed is absolutely right that fees, in general, have been declining in our industry over time. That is a good thing and something that we're fully supportive of. For a little context, the average actively managed equity ETF actually has an expense ratio of 0.87%, and the average index equity ETF has an expense ratio of 0.52%. So we like where we are in terms of delivering value. What you hear about most of the time are the Vanguards and the Fidelities of the world who charge 9 basis points for pure index-like returns.

It's a great opportunity to remind everyone that the Motley Fool 100 ETF is not exactly that. We were excited to launch this because we feel that it harnesses the great investing talent at our sister company, The Motley Fool, and a publishing business, and the securities that underlie the index there are actively chosen by our great team of analysts at The Motley Fool.

Gardner: Before we go to the next one, so there is a distinction here between actively managed ETFs and then passively managed, and the passively managed, kind of robo-ETFs, buy the whole market. Vanguard's made themselves famous for having very low, cut-rate fees. Those are often cheaper, but you're pointing out that with The Fool 100 ETF, this is an actively managed fund. The stocks change, even from one month to the next. It's not just the same hundreds nailing it in every year.

Hinmon: That's correct. The index is reconstituted quarterly, and it's important to remember that the underlying securities in the index are active recommendations by Motley Fool newsletter services or high-conviction ideas of the analysts back there.

Gardner: Awesome! Thank you, Bryan. Thanks for that explanation, and thank you, Ahmed, for writing in.

The second one comes from Cliff Kaeda, and he asks a question -- well, one of the reasons I have my guest stars on the show is often I don't know a lot of things, as I hope any Rule Breaker Investing podcast dyed-in-the-wool listener already knows. Dave doesn't know a lot about the world at large, so he makes friends with people who know and then he has them on the show to explain, so I really like Cliff's question here.

He wrote in so many words, "Hi. Sorry, way behind in my podcast listening due to recent travels. Bryan Hinmon" -- who, by the way, is with me right now -- "talked about the small-mid cap growth funds," the last time you were on the podcast, Bryan. He said, "I have one question about this fund based on the name." Cliff writes, "If a holding becomes a large cap" -- i.e., let's just say it started as a small cap, did really well, and becomes a large cap -- "do they sell it? This might be in the prospectus." Cliff confesses he's too lazy to read it.

He adds a related question, this one similar but interesting. "I suppose you could ask the same about Emerging Markets Fund. What if China is no longer considered, at some point, emerging?" Let's say in the next five years. "Would a fund sell all its Chinese stocks?" What's your take?"

Hinmon: This is a great question by Cliff, and these are problems that we want to deal with. If a small cap grows up to be a large cap, we're happy to deal with that.

Gardner: Yup.

Hinmon: In the industry writ large, we have to write a prospectus which lays out the strategy and rules by which we will hold ourselves as we manage the portfolio. Specific to the Motley Fool Small-Mid Cap Growth Fund, we have wording in our prospectus that you can read at FoolFunds.com that says at least 80% of the fund's assets have to be invested in small- and mid-cap U.S. companies. So we have a 20% carveout, not so that we can invest in large cap companies, but so that we're not forced sellers, because we are absolutely buy-to-hold, long-term investors.

Gardner: You bet. And that's a great answer. Bryan Hinmon, I think we'll leave it right there.

Two fine answers to two excellent questions, and keep those questions coming. Now, I think a lot of people tune into Rule Breaker Investing, perhaps ironically, because they're not really that into funds. They love talking about stocks, directly, or strategies. That's what I'll be doing the rest of this podcast, but I have noticed with the launch of some of our funds that we're hearing more interest out there, in Podcastville, so we're more than happy to speak to it and having Tim Hanson and Bryan Hinmon on this show is really a special asset that I have, that I can bring these kinds of Fools on and help answer your questions. So great questions, great answers. Thank you, Bryan!

Hinmon: Always happy to be here, David.

Gardner: Bryan, is there an exit disclaimer that you either need to or would like to read? Anything you'd like to say as you leave?

Hinmon: I think the most appropriate thing would be just to have Rick play me off with some polka music.

Bryan Hinmon is an employee of Motley Fool Asset Management, a separate, sister company of The Motley Fool, LLC. The views of Bryan Hinmon and Motley Fool Asset Management are not the views of The Motley Fool, LLC and should not be taken as such.

The Motley Fool has a disclosure policy.