The Method Behind Schwab's ETF Price-Cutting Madness

Photograph by Daniel Acker/Bloomberg

On Sept. 21, discount brokerage Charles Schwab effectively threw down on Wall Street by slashing expenses on each of its 15 exchange-traded funds, some to as low as 0.04 percent. Investors in Schwab’s U.S. Broad Market and U.S. Large-Cap ETFs will now pay just 40¢ a year for every $1,000 they put into those funds. By specifically comparing these tiny expenses with higher fees docked by Vanguard and State Street ETFs, Schwab has effectively dared them, and by extension BlackRock, the parent of ETF leader iShares, to follow suit. In two cases, for example, State Street’s SPDRs now charge five times as much as Schwab’s corresponding index ETFs. “In this period of uncertainty in the markets,” said Schwab Chief Executive Walt Bettinger in the announcement, “the expenses investors pay are the only sure thing.”

Industry-provocation is quintessential Charles Schwab. In 1975, when regulators outlawed Wall Street’s fixed commissions, Schwab decided to go discount. In the late 1980s and 1990s, it was a trailblazer in cut-rate telephone and online trading.

But 2012’s Schwab might seem poorly positioned to lead a price war. The San Francisco brokerage house is merely the No. 12 player in a business dominated by BlackRock, Vanguard, and State Street, having started to offer ETFs only in 2009. Schwab’s shares have largely treaded water during a three-and-a-half-year bull market that has seen U.S. stocks double. That backdrop would normally have the nation’s best-known discount broker in clover. But the market’s trading volumes remain anemic, as does the appetite clients show for making numerous $9 stock trades. And with interest rates so low for so long, Schwab has been unable to reinvest profitably all the cash that clients have stockpiled at the broker, which also has an FDIC-insured bank.

So Schwab is spearheading the radical idea of selling the bare bones “market” as a loss leader, to get clients in the door to spend their cash on more profitable services. “From a timing standpoint, it makes sense to become increasingly relevant in ETFs, as low rates and declining equity transaction volumes make it harder to [increase] earnings,” says Faye Elliott of BGB Securities in an e-mail. “But here is the real benefit: The more relevant Schwab becomes in ETFs (the product du jour), the more likely they are to attract or maintain” bank sweep account or Schwab advisory products, businesses where she says the company wrings out far more per client dollar.

Across Wall Street, equity mutual funds and actively managed stock portfolios have historically provided a deep profit center for multiple middlemen, what with their offers of embedded fees and commissions to brokers and even bank tellers who successfully sell them.

But that is all being challenged by a prolonged national distaste for equity investing. Since the fall of Lehman Brothers four years ago, a net $410 billion has fled equity funds, according to the Investment Company Institute. During the past five years of tumult, the majority of active equity managers have lagged the Standard & Poor’s 500 Index (PDF)—even as the average large stock mutual fund charges 1.12 percent, or six to 10 times what a cheap S&P 500 index fund or ETF costs, according to Morningstar.

It is amid this backdrop that bond and money market assets have eclipsed those of equity funds at Fidelity, the Boston mutual fund behemoth that was once synonymous with the long-running “cult of equity.” Meanwhile, in the past three years, the majority of big discount brokers, including Fidelity, TD Ameritrade, and Schwab, have offered clients commission-free trades on entire rosters of ETFs.

Put it all together, and you have to wonder if Schwab had much to lose by provoking a price war in ETFs, a business that represents a mere $8 billion of its nearly $1.9 trillion in client assets.

As for the rest of the Street, the stakes could be far higher. Josh Brown of Fusion Analytics, who blogs as the “Reformed Broker,” thinks Schwab’s unlikely move could upend the $50 trillion wealth management and financial services industry. The implications, he says, are profound: What if you could invest in the market for a cost of zero? How many business models are improved by this in the industry and how many destroyed? How many are even prepared to ponder such a model? Do you match or beat Schwab? And then what if Schwab counters?

“It’s becoming like banks giving away free checking to get you in the door,” says Brown. “But you know what? Tap water’s also free, but they still sell Dasani. The ‘market’ can be free, while things you sell on top of it and around it are profitable. Schwab’s being early on the inevitable.”

In the meantime, be on the lookout for retaliatory fee-cutting press releases—and self-congratulatory client notifications—from the likes of BlackRock, Vanguard, and State Street.

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