Dear Dagen: Price War May Be in the Offing for Index Investors

Barclays is expected to undercut the expenses of Spiders.
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A price war may be coming to the hottest area of the mutual fund market. And

Barclays Global Investors

is poised to fire the first salvo.

Sometime in the first half of next year, Barclays is expected to offer a cheaper competitor to the largest exchange-traded product,

Standard & Poor's Depositary Receipts

(SPY) - Get Report

, commonly known as Spiders.

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Three people in the exchange-traded products industry expect the annual expense ratio on the Barclays product to come in between 8 and 14 basis points (or 0.08% to 0.14%). Even on the high end of that range, this product would dramatically undercut the cost of existing S&P 500 index portfolios, exchange-traded or otherwise.

The Spider carries annual expenses of 0.18%, identical to the expense ratio for the $95.7 billion

(VFINX) - Get Report

Vanguard 500 Index fund.

A Barclays spokesman says that the firm has not disclosed the expenses on the product yet.

The cheaper price could push other indexing firms to lower their own fees. That's nothing but good news for both retail and institutional investors.

Price Competition Looms

If Barclays launches its S&P 500 fund with lower expenses as expected,

State Street Bank & Trust

, trustee for the Spiders, will surely have to follow suit with the Spider, either matching those fees or going even lower.

"We're considering the matter closely. We haven't decided what we are going to do," says Gus Fleites, head of exchange-traded products at

State Street Global Advisors

, the bank's money management division. "If we need to do something, we will definitely take some action as the time comes."

Even

Vanguard

is watching the situation. Founder Jack Bogle does emphasize that exchange-traded index products are geared toward short-term investors. "So far, the index fund is pretty unbeatable for the long-term investor. And the Spider is absolutely unbeatable for the short-term speculator."

Bogle points out that a price reduction of a few basis points might be insignificant to short-term traders. "If you are only in the fund for four days, you don't care about the annual expenses."

However, Bogle does concede that if exchange-traded products become a competitive threat, then Vanguard is "not precluded from entering into the competitive fray."

"We're not stupid," he says. "We're looking at the possibility of creating a Spider series."

More Investor Choice

Unlike traditional index mutual funds, exchange-traded portfolios permit investors to trade shares throughout each trading day, like stocks. Mutual funds like the Vanguard 500 only price at the end of the day. Also, investors must pay commissions to buy and sell exchange-traded shares.

Exchange-traded products have been around since the early '90s, but this year they've attracted a lot more attention. The

Nasdaq 100

tracking stock

(QQQ) - Get Report

, which made its debut early in the year, has attracted $4.3 billion in assets.

Then Barclays, the world's largest indexer, announced its plans to roll out a large family of the products. That move was arguably the first real sign that these products posed a competitive threat to traditional funds.

Barclays has filed to launch 51 exchange-traded funds, but surely its pivotal product will be the one that tracks the S&P 500. S&P 500 mutual funds already command more than $223 billion in assets, according to

Lipper

.

Naturally, a lower fee would attract attention and give the product some leverage at its start. Barclays also plans to spend millions on an advertising campaign, which is being crafted by

Saatchi & Saatchi

.

More Key Features

Beyond the underlying expenses, the increased competition could narrow the bid/ask spreads for both the Barclays S&P 500 product and the Spider. With a new but similar product like the one coming from Barclays, a specialist on the exchange can make inroads in the market by narrowing the bid/ask spread. (The bid/ask spread is the difference between the highest price that a buyer is willing to pay and the lowest price the seller is willing to accept.)

For people actively trading these securities, the spread might be more important than the expense ratio.

Another important concern is how well the fund or portfolio tracks the index.

The upcoming Barclays product is structured as a mutual fund, while the Spider, which was launched in 1993, is constructed as a unit investment trust. The differences in the structures are technical and not worth worrying about except in the following instance.

In a rising market, the performance of the Spider can experience a "dividend drag." Because it's a UIT, dividends cannot be immediately reinvested but must remain in cash-like instruments until the quarter's end. That can drag performance in a soaring market. If the market is falling, however, this small amount of cash could result in a small performance premium.

With the S&P 500's yield at 1.2%, the average investor probably won't see the impact of dividend drag on the Spider's current performance. But "eventually when the market regains its sanity and the yield comes back up, it will be more of an issue," concedes State Street's Fleites, who says his firm "is looking into fixing that."

This is one battle where investors have nothing to lose.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.