“There is no price war. We have to move on from this myth about a price war.” – Laurence Fink, CEO of BlackRock via FT

“If Delta, United and Southwest all slashed ticket prices within weeks of each other, would you call it a fare war? #GMAFB”  – John Spence (@etftrendwatcher) via Twitter

There is good reason Laurence Fink does not want to acknowledge the prospect of an ETF fee war, because it would put a crimp in the profitability of iShares the nation’s leading ETF provider. In other industries, like consumer technology, falling prices are a way of life. In the world of investment management falling prices are a rarity. In that light the parallels between tablets and ETFs become pretty interesting.

Earlier this week rumors spread that Amazon was interested in buying the smartphone and tablet chip business of Texas Instruments. This marks the continuation of a trend of technology companies buying key component makers. In 2010 Apple purchased the designer of the A4 chips that then powered the iPad. In 2011 Google announced the acquisition of Motorola Mobility a longstanding Android partner.

These leading companies recognize that there are some functions that are simply too important to outsource to partners, albeit trusted ones. The same trend is at play in the world of exchange-traded funds, or ETFs. ETF sponsors are increasingly becoming “self-indexers.” If you think of the underlying index as the ETF’s “processor” then this trend parallels what is going on with the smartphone makers. Some providers like WisdomTree started off as self-indexers but other firms now recognize that outsourcing is a risky proposition.

There are two main reasons for this. The first is that it allows for a greater ability to control the index construction process. As ETF providers increasingly shift towards more niche-type products being able to design new indices can represent a competitive advantage. The second reason is that in the increasingly cutthroat world of ETFs even small costs can affect fund pricing. Funds that outsource index construction to third party like S&P or MSCI are often on the hook for higher fees as fund assets grow.

Whether you call it a “price war” among ETF providers or simply “increased competition” as Laurence Fink acknowledges, costs matter in a world where ETF pricing is under pressure. While the emphasis today is on ETF that are targeted toward buy-and-hold investors the prospect of a wider ETF pricing war is out there. Charles Schwab kicked things off a few weeks ago with across-the-board cost cut on a range of ETFs. Soon thereafter Vanguard announced a slew of index changes motivated in part to cut index fees. Now Blackrock itself is cutting fees on existing funds and starting up new funds to compete in the area of low cost index ETFs.

It’s not clear that the expense ratios on many of these funds can go all that much lower in the near term. Of course, stated expense ratios are not the only cost investors should consider when selecting ETFs, but it does represent the biggest factor. Many of these ETFs now sport expense ratios under 0.10% per annum. The biggest driver to-date of lower ETF fees has been Vanguard which has consistently taken market share in part because its cost structure is simply lower than that of the for-profit players.  The bigger question is whether other classes of ETFs can resist the gravitational pull of lower fees. With an increasing number of ETFs closing in 2012 the challenges for marginal players will only increase.

It’s hard to see how these ultra low cost ETFs represent anything but upside for investors. These funds allow retail investors to own broad asset class ETFs with expense ratios that many institutional investors would have been envious of just a few short years ago. Every study of fund performance shows that higher expense ratios are associated with lower returns. Therefore these ultra low cost index ETFs represent the culmination of a trend toward low cost, index investing started decades ago.

That being said the vast majority of assets under management remain embedded in open-end mutual funds. While ETFs have made significant inroads by accumulating in excess of $1.2 trillion in assets in the US it still represents the tip of the asset iceberg. The new form factor, that is the ETF structure, has the potential to be the building blocks for new models for investment management.

The iPhone and iPad helped unleash an entire “app economy.” While the form factor of these devices is interesting, some might say even beautiful, it is only when it is loaded with interesting apps do they become game changers. The same could be said about low cost index ETFs as well. While low costs are great, thing get really intriguing when ETFs can help unleash new and improved investing solutions from the growing number of online algorithmic investment managers. In a world of zero short-term interest rates, where obvious investment opportunities look limited, it is heartening to see innovation, for once, work for the individual investor who get to reap the rewards of the ETF “price war.”

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