Analyzing the business model of ETFs: Why management companies and securities companies can earn money even with low trust fees

Even if it is 0.05%, if it is 5 trillion yen, it will be 2.5 billion yen.

Low-cost index ETFs generally offer low returns and high sales. Even if the profit margin is low, if you can collect AUM, it will be a good business.

From the perspective of a management company, the key issue is not how low the trust fee is, but how much AUM can be collected to multiply that fee. Index licensing, legal affairs, disclosure, custody, listing maintenance, systems. Before these fixed costs are absorbed, small-scale ETFs do not make as much money as expected even if their balance increases. Once a certain scale is exceeded, additional AUM becomes more likely to fall into profit.

Securities companies here refer to financial institutions that are primarily involved as APs or market makers. While management companies earn money from AUM, APs and market makers calculate profits and losses separately. Manage profitability by treating pricing, spread, hedging, setting and exchange of customer orders as one transaction. If the market is rough, the spread will widen. This is not just a malfunction, but also a defense against holding inventory when the appropriate price of the underlying asset is unknown.

Investors benefit from this division of labor with lower holding costs and intraday liquidity. The cost hasn't disappeared. Beyond the easy-to-see trust fees, there remain buy-sell spreads, price deviations, exchange rates, taxes, and market impact.

Management companies earn money by accumulating AUM

ETF management fees are basically deducted from the fund's net assets on a daily basis. For example, if AUM is 5 trillion yen and the annual rate is 0.05%, the annual cost is 2.5 billion yen. If you just look at the numbers, it's big. However, this 2.5 billion yen does not remain as profit for the management company.

Even at the same 0.05%, if AUM is 50 billion yen, the annual cost is 25 million yen. Considering index licenses, audits, listing maintenance, systems, and personnel, this is quite thin. Even if the rates are the same, products worth 5 trillion yen and products worth 50 billion yen are two different businesses.

Depending on the product, the cost structure will vary, including allocation to management companies, trustee companies, management companies, etc., index licensing, listing, auditing, buying and selling, and storage. Japanese ETFs display "trust fees," while overseas ETFs display "expense ratio" and "management fee." If you want to compare, you need to look at the prospectus and investment report.

What you should pay attention to when looking at AUM is how it increases. Did the market value of the assets held increase due to the rise in market prices, or did new funds come in from investors? Even though the same AUM increase of 10%, the meaning is quite different.

Increases due to market appreciation will boost profits, but the opposite will occur if the market goes down. Net inflows easily indicate sales strength and product competitiveness, and can also serve as the basis for compensation from the next period onward. When looking at management company stocks, you want to check the net inflows before looking at the total AUM.

Even if your AUM increases by 10%, if your average compensation rate decreases by 15%, your compensation income will not increase. The stronger the inflow of funds into low-cost ETFs, the lower the unit price will be even if the balance increases. This combination is surprisingly effective for management company financial results.

The troublesome thing about management company stocks is that even if the market price rises, AUM will increase and business performance will look good. When stock prices rise, compensation income naturally increases, but when market prices collapse, AUM declines and investors cancel their contracts. The weaker the net inflow of a company, the more likely it is that its profits are dependent on market conditions.

Operating an ETF is not a job where staffing and system costs are completely doubled just because the balance doubles. That's why scale matters. The opposite is true for small products that cannot absorb fixed costs. The balance is small and the spread is wide, making it difficult to collect funds. Just arranging products will not improve profitability.

What is important for a management company is not the number of ETFs, but the number of mainstay products that have sufficient AUM and liquidity. ETFs that do not accumulate balances can be left as long as they are used as advertisements. However, if the inflow of funds is not expected even if the index license and listing maintenance fees are continued to be paid, the stock will be subject to liquidation. If you evaluate product development capabilities solely by the number of new products, you will overlook this exit cost.

Stock lending is a source of income, but the allocation varies depending on the product.

Securities lending, in which stocks held by ETFs are lent to institutional investors and fees are earned, can be a source of income that compensates for tracking differences. Funds that hold stocks with tight supply and demand may have an increased presence of loan income.

However, it is unfair to uniformly describe stock loan income as "the management company's hidden profits." Some designs return most or part of the proceeds to the fund, with the lending agent receiving the remainder. For example, some iShares products disclose that 62.5% of the stock lending income will be allocated to the fund and 37.5% to the stock lending agent. Ratios vary by product and jurisdiction, and some ETFs do not lend.

Furthermore, stock lending requires risk management such as the creditworthiness of the borrower, collateral value, and operation. It is only by looking at loan ratios, collateral, profit distribution, and the presence or absence of compensation, rather than just looking at profits, that you can evaluate whether the structure is advantageous for investors.

How do APs and market makers make money?

AP is a financial institution that can create and exchange directly with funds in the ETF primary market. With the in-kind contribution type, the basics are `setup'', in which you hand over a designated stock basket and receive a large ETF, and `exchange'', where you hand over the ETF and receive a stock basket. Some products require cash, and not all products are exchanged in kind.

If the market price of the ETF is higher than the value of the underlying assets, you can consider trading by buying the underlying assets and selling the ETF. If it is undervalued, there is room to buy the ETF and sell the underlying asset. Transactions involving such creation and exchange increase or decrease the supply of ETF units, bringing the market price closer to the value of the underlying asset.

The textbook ends with one line: ``Arbitrage works if there is a price difference.'' It's different in the field. Arbitrage does not occur automatically the moment a price difference is seen. It moves only when there is a profit remaining after deducting hedging costs, stock borrowings, financing, and creation/exchange fees.

Even if AP finds a price difference, if the underlying asset cannot be purchased at the expected price, the profit will disappear. Overseas markets are closed, there is little interest in bonds, and the linkage with futures has collapsed. In such cases, the hedging error increases and the hurdle to arbitrage increases.

It is for the same reason that market makers widen the spread. Even if it appears that they have abandoned pricing, in reality they are often adding price uncertainty and inventory risk to market prices. If you continue to offer a narrow spread, you can force the other party with the information to execute at a disadvantageous price. Wide spreads when markets are rough are also an insurance premium for liquidity providers to remain.

When the spread widens during a sudden market change, it appears to investors that the broker is making too much money. However, if the price of the underlying asset is not visible and the price is the same as in normal times, the market maker will incur a unilateral loss. If profitability collapses, the presence itself will eventually disappear. Tight spreads are not a good thing, they are the flip side of hedgability.

Please note that AP and market maker are not necessarily the same. An AP is an entity that has the qualifications for setting and exchanging, and a market maker is an entity that presents buying and selling quotes to the market. In some cases, one company is responsible for both, and in other cases, a market maker sets up and exchanges via AP.

Is it easier to manage than unlisted investment trusts?

What supports the efficiency of ETFs is that most of the buying and selling by individual investors is completed in the secondary market. If person A sells and person B buys, there is no need for the fund to immediately sell its holdings. Retail trading can be separated from the fund's asset trading. This is a very convenient structure for management companies.

It is also different to declare that "customer management will be completely transferred to the exchange" or "there will be no buying and selling costs." Securities accounts are managed by selling securities companies, and exchanges, clearing institutions, trust banks, and custodians are also involved. Intra-fund transactions also occur when creation and exchange are performed in cash, or when responding to index swaps, distributions, and capital outflows and inflows.

In the US, it has been pointed out that spot exchange has the tax advantage of making it easier to reduce capital gain distributions, but this effect cannot be directly applied to Japanese investors. Treatment varies depending on the fund's domicile, investment target, account classification, and tax system.

Why are management companies increasing the number of high-priced ETFs?

The more price competition there is in a broad-based index ETF, the better it will be for investors. However, from the perspective of management companies, it is also a product that lowers the average fee rate. It will be successful if enough AUM is collected, but it will be difficult for generic products to challenge major major ETFs with only low rewards.

This is where we expand into income strategies that use active management, themes, segmented bonds, and options. Since it takes time to operate and explain, it is easier to set higher rewards. For management companies, it is a way to protect the unit price of revenue, but for investors, high fees do not mean high returns.

If you look at it as a business strategy for a management company, it is a combination of capturing the customer base and AUM with low-reward core ETFs and increasing the unit profit with high value-added products. From an investor's perspective, they should look at returns after expenses, buying and selling costs, and the reproducibility of investment methods, rather than flashy distribution policies or themes.

The real cost for investors is not just the expense ratio.

If you only look at trading volume when choosing an ETF, you may misinterpret liquidity. Even if an ETF has a thin shelf, there is still room to fill large orders if the underlying assets are liquid enough and APs and market makers can create, exchange, and hedge. Conversely, even if the trading volume of an ETF is high, if the underlying market is closed or the prices of the underlying bonds cannot be seen, the spread will widen rapidly.

What you need to look at is not just the ETF's volume, volume, and spread. Liquidity includes the trading value of the underlying asset, the depth of futures, the overlap of trading times, the number of APs, the number of market makers, and the track record of creation and exchange.

Price adjustments are powerful, but neither automatic nor unlimited. When the underlying asset market is closed, suspension of creation and exchange, extreme volatility, and withdrawal of APs, arbitrage costs increase and the gap between market price and NAV widens.

It is also dangerous to become complacent by looking only at narrow spreads during normal times. The ease of using ETFs will depend on how much liquidity providers can provide during times of stress. It is also important for investors that the market maker is profitable enough to avoid exiting the market.

Spreads are often overlooked by investors. When investing 1 million yen, the difference in expense ratio of 0.01% is 100 yen per year. If you buy 1,000,000 yen worth of stock and immediately sell it without the price moving, if the proposed spread is 0.10%, you will bear the price difference of about 1,000 yen by simple calculation. The actual execution cost will vary depending on the order method and board, but a single purchase and sale can amount to years of expense ratio differences.

Continuing costs are effective for long-term holdings, while spreads are effective for short-term buying and selling. Even among ETFs that track the same index, the product with the lowest expense ratio may not always be the cheapest to use.

People who look at management company stocks see different numbers.

When looking at management company stocks, the first thing you want to check is the net inflow, not the total AUM. AUM that increases when the market goes up will decrease when the market goes down. If net inflows continue, average compensation rates are maintained, and the ratio of active and high value-added products increases, the quality of earnings is likely to improve. On the other hand, if the number of products increases and there are many closures, economies of scale will be difficult to achieve.

The size of AUM alone is not enough. The actual situation is reflected in the breakdown of capital inflows, average fee rate, profitability for each product, redemption rate, profit distribution of stock lending, depth of market makers, premium/discount, and spread. Investors who buy ETFs look at the ease of use of each product. Investors who look at management company stocks look at whether the product group will generate profits. Even though the ETF is the same, the screens you see are different.

summary

The low fees offered by ETFs are not the result of management companies giving up on making money. Collect AUM, absorb fixed costs, release retail sales to the secondary market, and have APs and market makers take charge of price adjustment. Division of labor and economies of scale reduce the cost per unit.

However, economies of scale only work for core products. Rather than having a large number of ETFs, it's more about how many products you have that have continuous net inflows, sufficient balance, and liquidity. This is where the management company's earning power comes into play.

Investors should not only look at trust fees.平時には数ベーシスポイントの差が気になりますが、相場が荒れれば一度のスプレッドがその差を簡単に上回ります。 ETFs are low-cost instruments. However, the true cost becomes clear only when you consider when, what, and at what price to buy and sell.

source

• 日本取引所グループ「ETFの仕組み」
• 日本取引所グループ「ETFの指定参加者について」
• 日本取引所グループ「投資のリスク（ETF）」
• Investment Company Institute「ETF Basics and Structure: FAQs」
• Investor.gov「Updated Investor Bulletin: Exchange-Traded Funds」
• BlackRock「iShares Global Govt Bond UCITS ETF」