Schwab’s ETFs Are Gobbling Up a $2.4 Trillion Market

Generic funds can do well when you run a financial supermarket.

In the crowded race for a piece of the $2.4 trillion exchange-traded fund market, one contender is coming up rapidly from behind. Charles Schwab, better known for its low-cost brokerage, has attracted more than $10 billion to its ETFs this year. Only the three giants of the business—BlackRock, Vanguard, and State Street—added more money. Five years ago, Schwab wasn’t even in the top 10 of ETF managers by assets. Now it’s ranked fifth, with $54 billion in its 21 ETFs.

Schwab’s Cut-Rate ETFs Are Catching On
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Surprisingly, Schwab has done this while focusing on plain-vanilla investment options, where there’s stiff competition. ETFs are funds that trade like stocks, and the most popular ones, such as State Street’s $197 billion SPDR S&P 500 Trust, mimic broadly diversified market indexes, just like Schwab’s biggest funds do.

It’s tough to take on the established ETF brands—who needs another generic blue-chip index fund?—but Schwab’s products have had two advantages. First, “they are the cheapest of the cheap,” says Eric Balchunas, an analyst with Bloomberg Intelligence. Some of Schwab’s ETFs, including the one tracking large-cap stocks, charge investors annual fees of as little as 3¢ per $100 invested. Schwab’s least-expensive ETFs are even cheaper than those sold by Vanguard, a company known for low prices, though in most cases the gap is as small as 1¢ or 2¢ per $100 invested.

Schwab also benefits from being a financial supermarket that already reaches millions of customers. “It’s a large, captive audience,” says Ben Johnson, director of global ETF research at Chicago-based Morningstar. In addition to having 10 million brokerage customers, Schwab manages retirement plans for 1.6 million participants. About 7,000 financial advisers use it for trading and other back-office services.

Schwab says it sells a majority of its ETFs to existing customers, with roughly 30 percent of money coming in from new clients. In 2015 the company launched a robo-adviser, a web-based service that automatically builds clients a diversified portfolio; the service invests mainly through Schwab’s ETFs. Schwab’s new mutual funds for retirement investors also invest in its ETFs.

Schwab launched its ETFs in 2009, relatively late. Other newer entrants have chosen to bypass basic index funds to offer more novel strategies. For example, one ETF tracks companies that supposedly fight obesity, and another holds video-game makers. Except for a real estate fund, Schwab has no industry-specific ETFs. “Cost is the holy grail for the future of this industry,” says Marie Chandoha, head of Schwab’s asset management subsidiary. “We are not focused on niche products.”

Chart: Schwab’s ETF assets

Another popular strategy, called smart beta, is to build specialized indexes that weight stocks based on factors such as low valuation or dividends in an attempt to beat the market. No. 4 player Invesco has heavily embraced smart beta with its PowerShares funds. Schwab has a few such offerings, too, dubbed Fundamental Index funds, but so far they represent only 10 percent of its ETF assets. Smart beta charges more than the basic index funds—Schwab’s cost 32¢ or more per $100 invested.

Even with its growth, Schwab is far smaller than the biggest names in the industry. No. 1 BlackRock has more than $900 billion in assets in its U.S. iShares ETFs. Even Invesco has twice as much in ETF assets as Schwab with $106 billion. “Schwab will continue to pull in assets, but I don’t think you are going to see them reach a couple of hundred billion dollars overnight,” says Dave Nadig, director of ETFs at FactSet. The captive-audience model has its limits. “It’s a bit difficult to imagine Vanguard brokerage customers buying Schwab ETFs,” says Nadig.

And the price war is getting more intense. Goldman Sachs in 2015 launched a line of smart-beta ETFs with expenses of just 9¢ per $100 invested. That’s far cheaper than Schwab’s smart-beta offerings. On Oct. 5, BlackRock announced it would cut expenses on 15 stock-and-bond ETFs, matching Schwab in a number of fund categories.

Schwab’s Chandoha thinks price is going to become even more important. A new U.S. Department of Labor rule, which will go into effect next year, requires advisers dealing with retirement investments to put their clients’ interests first. One way to show you’ve done that is to put them in low-cost funds. “There will be a shakeout in this business,” says Chandoha, “and cost will be the driving force bringing in assets.”

The bottom line: Many ETF challengers avoid competing directly with the big brands. Schwab has the marketing muscle to do it.

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