Schwab Changes the ETF Landscape

I’ve been talking for years about the way exchange traded funds (ETFs) are changing the investment landscape. Yet sometimes I’m still startled to see the world change in front of my eyes. That’s exactly what happened last week when Charles Schwab launched its first four in-house ETFs.

Are these new funds revolutionary? Not really — all are core holding ETFs in areas already well-covered by other sponsors. What’s new and unusual is Schwab’s bold move to offer its online brokerage clients commission-free trading in its own ETFs.

Yes, that’s right: If you’re a Schwab client you can buy and sell any of these ETFs online with no transaction fee:

Schwab U.S. Broad Market ETF (SCHB)
Schwab U.S. Large-Cap ETF (SCHX)
Schwab U.S. Small-Cap ETF (SCHA)
Schwab International Equity ETF (SCHF)

Regulatory filings show that Schwab has other ETFs on the drawing board, too. So I think they’re planning to make a major splash in the world of ETFs over the next couple of years.

Free Trading Is Only
The Tip of the Iceberg

Free ETF trading may sink some ships.

In addition to the ability to trade online for free, the new Schwab ETFs have another interesting feature. Each has the lowest ongoing fees of any fund in its class. Check out these expense ratios:

SCHB: 0.08 percent
SCHX: 0.08 percent
SCHA: 0.15 percent
SCHF: 0.15 percent

The operating costs of the Schwab ETFs aren’t just cheaper than other ETFs. They’re also a fraction of what actively-managed mutual funds in the same classes have been charging for years!

Now, I’m usually not an advocate of choosing your investments based on price. I find that you often get what you pay for. Nonetheless, many investors see no reason to pay any more than they have to, and these low fees will be compelling to some of them.

Schwab is upping the ante for the whole investment management industry, just like it did for the brokerage industry back in the 1970s. And competitors will have to respond.

Why Trading Costs Matter

As I said in last week’s Money and Markets column about ETF trading, it’s not hard to find discount brokerage commissions in the $8-$12 range. So is being able to trade a few selected ETFs for free at Schwab really such a big deal? Yes it is. And here’s why:

Pension funds and 401(k) plans are a huge part of the mutual fund business. Maybe you have money in one of these plans right now. If so, you know that your investment choices are usually limited.

Many businesses would like to offer ETFs to employees, but right now they can’t. Partly, it’s an administrative problem. The custodial and record-keeping system is designed to process no-load mutual funds. They usually don’t offer ETFs because there is no way to add extra fees when an employee decides to make a trade.

401(k) assets are mostly in mutual funds today, but that could start changing soon.

But the bigger issue, I’m convinced, is that the mutual fund giants don’t want to let ETFs get a foot in the door. And because they have so much influence in the industry, no one has tried to work through the practical issues of getting ETFs into employer-sponsored retirement plans. That is … until now.

Schwab is breaking the oligopoly — and could be rewarded with billions in pension assets! Those pennies in fees add up quicker than you might think. And since Schwab already has a trading platform in place, offering free online ETF trades really doesn’t cost them very much. I think it’s a brilliant move.

Mutual Funds Should Be Scared

Schwab is about to revolutionize the ETF industry.

Back in the 1990s Schwab revolutionized the mutual fund world with their “OneSource” no-transaction-fee mutual fund supermarket. Prior to then, investors either had to go straight to each mutual fund outfit or pay transaction fees to buy all of their funds in one brokerage account. Now such one-stop-shop programs are by far the most common way to invest in mutual funds.

And Schwab is breaking the mold again. In one swoop, almost all of the arguments in favor of mutual funds over ETFs are gone. Trading commissions? Zero. Small accounts? No problem. Dollar cost averaging? Done.

The ones who lose in this picture are the ETF sponsors that are not attached to large online brokerage firms — which means most of them. iShares, SPDRs, PowerShares, ProShares, and others don’t have the distribution capability to compete with Schwab. Fidelity does, but it only has one ETF of its own (so far).

Look for these firms to either get in the brokerage business or strike strategic alliances with Schwab-like firms. They have no choice. In a few years it will be a matter of survival.

Of course, none of this means you should rush out and buy Schwab ETFs, not now or a year from now. Everyone has unique needs. My point is that the world is changing — and for the first time this decade, it’s changing in the individual investor’s favor.

Best wishes,

Ron

P.S. I’m now on Twitter. Please follow me at http://www.twitter.com/ron_rowland for frequent updates, personal insights and observations about the world of ETFs.

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