Huge profits made on low-cost ETFs

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Low-cost exchange traded funds are all the rage these days, both for investors who like the cheap management fees, and for fund managers who like the big profits they create.

That seems like an oxymoron. How can something with management fees around 50 basis points be worth so much?

Yet the numbers speak for themselves. Based on a new Deutsche Bank report, the Financial Times found that ETF managers are likely making four times more than the traditional mutual funds industry.

Using Deutsche Bank's numbers, and then comparing them to a recent McKinsey & Co. analysis of Europe's fund management industry, the Financial Times found that ETF's likely account for 13 per cent of the Europe's €9-billion in fund profits. More importantly, the profit margins on ETFs are sky high -- 55.5 basis points of assets under management for ETFs versus 12.5 basis points for traditional funds.

And within ETFs, there's a difference in profit margins between synthetic ETFs and physically replicated ETFs. The first type posts profit margins of 69 per cent, while the latter has profit margins of 64 per cent.

Synthetic ETFs work by using over-the-counter swaps, such as equity-linked swaps. This method can be beneficial because there's no need to worry about dividend payments and less fuss when indexes are rebalanced. In other words, less cost goes into managing them.

Past studies have found that over 50 per cent of assets under management in European ETFs are now placed in synthetic ETFs. However, it's worth noting that there are problems with these products. Because they are created using swaps, the ETFs are subject to counterparty risk. If the counterparty defaults, the investors could have problems.

As for physically replicated ETFs, the providers make their money on them through ancillary services such as securities lending and using the assets for swaps.

The Deutsche Bank report found that Blackrock is currently making the most money off ETFs in Europe, bringing in about 380-million euros in annual profit. With that kind of money, it makes sense that Korea's Mirae Asset Global Investments is looking to buy Jovian Capital Corp.'s 60 per cent stake in BetaPro Management Inc., which runs the Horizons BetaPro ETF Family for a reported $150-million. Also explains why RBC just announced its emergence into ETFs last week.