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INsider: The cost of commission-free ETFs

Schwab reportedly is putting together a commission-free platform — but there may be a catch

Dec 11, 2012 @ 11:17 am

By Jason Kephart

The Charles Schwab Corp. made a big splash three years ago when it offered the first exchange-traded funds to trade commission-free. Now the company may be on the verge of one-upping itself.

Schwab is in the process of creating a commission-free-ETF supermarket that will include products from a variety of providers,according to Reuters. Only Schwab's proprietary ETFs are currently available commission-free to its brokerage customers.

The hitch? None of the three biggest providers of exchange-traded funds, BlackRock Inc.'s iShares, The Vanguard Group Inc. and State Street Global Advisors has signed on board yet, according to the Reuters report. Those three hold 83.5% of the $1.3 trillion in assets in ETFs as of the end of November, according to Morningstar.

The sticking point reportedly is a 5- to 10-basis-point distribution and marketing fee Schwab has proposed the ETF providers pay to be on the platform. It would be similar to the 12(b)-1 fee some mutual funds charge.

The fee may seem small, especially compared with the 25 basis points mutual funds routinely charge in 12(b)-1 fees. But for the lowest-cost ETFs the levy could almost double or triple expenses. The $23 billion Vanguard Total Stock Market ETF Ticker:(VTI) charges 6 basis points. The $33 billion iShares S&P 500 ETF Ticker:(IVV) charges 7.

Further complicating matters is that Schwab charges only $8.95 per trade. So for some accounts, costs actually could go up, thanks to the free program.

In smaller accounts, such as a $100,000 portfolio, the fees don't make as much of a difference. Assuming a 5-basis-point fee, six trades (or a typical re-balance) would cover the costs of distribution and marketing.

Larger accounts could be adversely affected, however. A $1 million account would be charged $500 annually in distribution and marketing fees (again, assuming a 5-basis-point charge). An adviser would have to make 56 trades in that account before the distribution fees would be cheaper than the trading costs.

“It's the most expensive commission-free program an investor will ever see,” said Rick Ferri, founder of Portfolio Solutions LLC. A spokeswoman for Schwab declined to comment.

While the distribution and marketing fees could cause a headache for bigger advisers, it could be a pretty good deal for Schwab. The fees would give the brokerage a steadier stream of income than commissions, given trading volumes are at multiyear lows, as Reuters noted.

The proposed platform also suggests that Schwab has its eyes on grabbing a big piece of the ETF boom's coattails, said Ben Johnson, director of ETF research at Morningstar Inc.

“It seems from their perspective in line with a strategy to become a one-stop shop for ETF investors,” he said in an interview.

Schwab this month also launched an educational ETF website that brings together research from various ETF providers such as Vanguard, SSgA and Guggenheim Investments. Mr. Johnson pointed to it as another example of Schwab's reaching out to the broad ETF investor community, not just pushing its own products.

It's not surprising that Schwab wants to expand its ETF pitch to advisers beyond its own proprietary products. Even though brokerage offers the lowest-priced ETFs in the 15 categories in which it competes, its ETFs have failed to capture new deposits on the same scale as those from iShares and Vanguard. Schwab ETFs had $2.5 billion in inflows through November, while iShares and Vanguard each have had more than $45 billion, according to Morningstar.

Meanwhile, ETFs are on pace for their biggest year ever, Morningstar said. The passively managed low-cost vehicles had $154 billion in inflows this year through November, which puts them on pace to top 2008's $168.3 billion in inflows, the research firm reported Monday.

The new platform would make Schwab the first brokerage to offer advisers commission-free trading on an unlimited number of ETFs from multiple providers.

TD Ameritrade Holding Corp. offers commission-free trading on 101 ETFs from multiple providers, but the list is missing notable funds such as the $74 billion SPDR Gold Shares ETF Ticker:(GLD), the $42 billion iShares MSCI Emerging Markets ETF Ticker:(EEM) and the $30 billion PowerShares QQQ ETF Ticker:(QQQ).

E*Trade Financial Corp. offers commission-free trades of ETFs from niche providers WisdomTree Investments Inc., Global X Funds and Deustche Bank AG.

The question remains whether the new platform will attract new advisers or if the other platforms simply will copy it. At the end of the day, Mr. Johnson doesn't see it as a game changer.

“I don't think it's something that would necessarily drive massive amounts of assets on other platforms to Schwab,” Mr. Johnson said.

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