Charles Schwab’s dramatic gesture in September to cut the prices on all 15 of its ETFs looks to be more the stuff of catchy headlines and sexy marketing rather than a real enticement that will drive investors to quickly switch to Schwab, an informal IndexUniverse survey of financial advisors found.
As is often the case with any subject matter, the more deeply one delves into the price cuts, the less clear things seem to become. Yes, the price cuts made the Schwab ETFs the cheapest in their respective classes, and yes, Schwab clients can trade those ETFs for free which, given the need to rebalance, is a great deal. You can’t blame Schwab for trumpeting the move with big ads in The Wall Street Journal.
But are the funds really cheaper when taking into consideration sometimes-overlooked variables such as bid/ask spreads? And how important is the fact that commissions Schwab does charge on, say, nonproprietary ETFs, are more expensive than what its arch rival Vanguard charges? And perhaps most relevant, are Schwab’s ETFs as good as the competition’s from a portfolio management point of view?
At the very least, it's clear that Schwab’s moves are the latest reflection of a deepening trend of downward pressure on prices across the financial services industry. But it’s also pretty clear that Schwab aims to attract investors and advisors to its platform and then charge them for products and services that will contribute to the San Francisco-based company’s bottom line.
“Schwab and others are not charities,” said Tyler Mordy, a financial advisor at Toronto-based Hahn Investment Stewards.
“But the flip side is that there’s a continuing pressure on fees,” Mordy added, stressing that the ETF looms largely in the dropping-cost scenario because asset allocation has never been so inexpensive and potentially thorough, given the growing number of available ETFs.
So, when Schwab Chief Executive Officer Walt Bettinger told journalists last week that the bold price cuts were motivated by what’s good for investors, it seems advisors do take Bettinger seriously, but only up to a point.
After all, Schwab's 15 ETFs don’t yet canvass nearly all the pockets of financial markets, meaning commissions are almost inevitable, and advisors seem to understand this pretty clearly.
And, as far as that goes, commissions at Schwab are about $9 a trade, compared with $7 at Vanguard for buying and selling securities that aren’t part of each company’s free ETF trading programs. That, too, adds up.
A Loss Leader
Moreover, it’s hard to get away from the conclusion that, after the price cuts, Schwab is losing money on its ETFs, according to Rick Ferri, head of Michigan-based registered investment advisor Portfolio Solutions and a well-known figure in the world of index investing.
That’s because we know that Vanguard—a mutual fund company that’s owned by its fund holders—runs its funds at cost as a matter of course. Vanguard’s funds are considerably bigger than Schwab’s, meaning it has better economies of scale than Schwab. So, if Schwab’s smaller funds are cheaper, it’s pretty obvious Schwab is losing money on them, Ferri said.
Ferri stressed that Schwab will try to use the cheap and commission-free ETFs as loss leaders.
“What they’re trying to do is get people to come to their platform,” said Ferri. “Get them into the store, then they’ll spend money there,” he added, noting Schwab is said to make good money on products such as its money market funds. Its Options Express unit is also said to be very profitable.
A Vanguard official made clear that Vanguard will never use a loss-leader approach to selling its funds, again, because it’s owned by fund holders, and such a policy would violate its at-cost pricing policy.
“If it is a loss leader for them, we just wouldn’t be pulled into that,” Vanguard spokesman Dave Hoffman said in a telephone interview. “We would also ask, how long can a company play that game?,” Hoffman added.
“We don’t view reducing our prices as being competitive. We reduce our costs because it’s a function of our structure. We pass on savings with increased assets.”
A bigger concern for Ferri is that Schwab’s ETFs are organized around indexes using representative sampling strategies that don’t own all the securities in the index. That differs from Vanguard, which replicates the indexes its funds are built on. For a pure passive investor like Ferri who believes owning the whole market is superior to owning a sliver of it, that distinction matters.
"It’s not just about the fees, they’re tracking different indexes,” Ferri said, noting that sampling strategies often lead to more tracking error than replication strategies, which, in turn, can detract from returns and obviate advantages of a lower expense ratio.
That said, Ferri, who uses Schwab’s platform, said he sometimes uses Schwab’s ETFs for tax-loss harvesting. He said he parks assets in the funds after liquidating a position to deal with the “wash sale” rule that prohibits recording a tax-loss benefit if a given losing position is sold and re-established inside of a 31-day period.
Another element that’s worth considering is the bid/ask spreads on the Schwab ETFs, which add to overall costs of a fund.
Unsurprisingly, Vanguard seized on this in the immediate aftermath of Schwab’s price-cut announcement, saying trading spreads on its funds were narrower than on Schwab’s, obviating the advantages of the Schwab price cuts.
Self-serving? Yes. But also true, according to numbers we ran independently here at IndexUniverse to verify.
Take the Schwab U.S. Broad Market ETF (SCHB), $1.1 billion fund and the biggest of Schwab’s 15-fund lineup. Schwab slashed the expense ratio on the fund by a third to 0.04 percent, or 4 basis points—making it 2 basis points cheaper than the Vanguard Total Stock Market ETF (VTI).
But in August, bid/ask spreads on VTI averaged 2 basis points compared with 5 basis points for Schwab’s SCHB, making VTI’s all-in cost 8 basis points compared with 9 basis points for SCHB, according to data compiled by Vanguard.
Such distinctions are deep “inside baseball” to be sure, but they also represent real money to real investors. Of course, bid/ask spreads are a moving target, and are likely to grow narrower for Schwab’s ETFs as the assets in its funds increase over time.
Not ‘Earth Shattering’
In the end, it will take time for Schwab’s low-cost strategy to pay dividends.
But if history is any lesson, Schwab will continue to get traction with its offering of low-priced ETFs—all the more so now that its funds have the lowest expense ratios in the industry. Individual, self-directed investors, perhaps more than advisors, will be quicker to take note of the Schwab price cuts, Ferri said.
So far, the company has amassed more than $7.5 billion in proprietary ETF assets since rolling out its first funds in November 2009, which is undoubtedly a success given the increasing competition in the ETF industry.
Looking ahead, as IndexUniverse President of ETF Analytics Matt Hougan said last year in a podcast ironically titled "Can Anyone Stop Vanguard?," it’s not hard to imagine that in a few years, Schwab’s ETF assets will have grown substantially to as much as $30 billion to $40 billion.
But it will be a slow grind and, for now, while the price cuts are definitely noteworthy, they’re probably not enough to immediately open the floodgates of asset inflows to Schwab. What's more, Schwab has been slow and methodical in the way it has rolled out new products, which has worked to its advantage in terms of developing brand awareness without overcommiting resources.
The slow pace of change advisors seem to be predicting is related to considerations such as spreads and stealthy commissions, but also to simple logistical headaches that are likely to discourage asset movements in any case, advisors said.
“If you’re on the Schwab platform, it’s a real draw,” said Casey Smith, president of Wiser Wealth Management, a Marietta, Ga.-based RIA that uses TD Ameritrade to custody its assets. “But the price cuts aren’t earth shattering.”
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