Schwab's Commission-Free ETFs: A Watershed Event

Yesterday, November 3, 2009, marked a watershed event for the ETF landscape. It’s the day that Schwab (SCHW), absent from the ETF industry for past 16 years, upped the ante for any company thinking about getting into the business. Charles Schwab Investment Management, Inc. launched its first four ETFs.

At first glance, the new Schwab ETFs are nothing special – just four broad based core holdings, just like dozens already available from other fund companies. But look closer, and you will see they are also the lowest fee funds within each of their respective asset classes.

Look yet again, and see that these ETFs are also commission-free for Schwab brokerage customers. This is historic. Just as no-load no-transaction fee mutual funds changed the mutual fund landscape, commission-free ETFs will forever alter the way that ETFs are perceived. With this one change, nearly every argument in favor of mutual funds instead of ETFs goes away. Dollar cost averaging? No longer costly with commission-free ETFs. Small account size? Not a problem anymore.

Schwab has arrived, and they didn’t do it quietly. Now all eyes will turn to the competition to see how they react. Will other brokerage firms roll out their own ETF brands? Will iShares and SPDRs get into the discount brokerage business? “Strategic alliances” will be discussed, but in all likelihood are not feasible since there are not enough fees to share. Schwab has erected a significant barrier to entry and is now well positioned to go after the lucrative 401k market.

The four new ETFs launched by Schwab:

• Schwab U.S. Broad Market ETF (SCHB) (SCHB overview) will track the Dow Jones U.S. Broad Stock Market Index with a 0.08% expense ratio. The underlying index represents the largest 2,500 U.S. equities and is float-adjusted market cap weighted.
• Schwab U.S. Large-Cap ETF (SCHX) (SCHX overview) will track the Dow Jones U.S. Large-Cap Total Stock Market Index with a 0.08% expense ratio. The underlying index represents the largest 750 U.S. equities and is float-adjusted market cap weighted.
• Schwab U.S. Small-Cap ETF (SCHA) (SCHA overview) will track the Dow Jones U.S. Small-Cap Total Stock Market Index with a 0.15% expense ratio. The underlying index represents the stocks ranked 751–2,500 of the largest 2,500 U.S. equities and is float-adjusted market cap weighted.
• Schwab International Equity ETF (SCHF) (SCHF overview) will track the FTSE Developed ex-US Index with a 0.15% expense ratio. The underlying index covers1,400 large cap and mid cap stocks from more than 20 developed international markets.

Online trades of Schwab ETFs are commission-free at Schwab, while trades of third-party ETFs are still subject to commissions.

Unfortunately, the first day of trading had some glitches. SCHA traded at the wrong price for the about the first ten minutes with those who bought early receiving about a 10% discount from NAV, unless those trades get busted. SCHX appeared to have a similar problem but fewer shares were involved. Market makers had trouble maintaining the appropriate depth on SCHB, and it appears some larger orders created price spikes. SCHF had the most orderly first day of the bunch.

Schwab expects to offer four additional ETFs in December: Schwab U.S. Large-Cap Growth ETF (SCHG), Schwab U.S. Large-Cap Value ETF (SCHV), Schwab International Small-Cap Equity ETF (SCHC), and Schwab Emerging Markets Equity ETF (SCHE).

Additional Information: press release, Schwab ETF website, prospectus download page

Disclosure compliant with FTC 16 CFR Part 255 covering writer, editor, and publisher: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.

• More on choosing the right ETF

Comments

[Ron Rowland:]

Trading problems with SCHB at the open this morning:
2 trades at $435.99
9 trades at $399.99
25 trades from $400.00 to $400.11
12 trades at $499.99
Market maker lowers Ask to $27 at 9:30:09
1 trade at $27.00
First trade at reasonable price of $24.75 at 9:30:13

Never use “market on open” orders with ETFs (even if it is commission-free).

Nov 04 10:48 AM

[Windsun33:]

Looks like about the only big brokerage house left to come out with some ETF's is Fidelity.

Nov 04 11:30 AM

[Windsun33:]

I think that advice applies to almost any stock. Blind "Market on Open" can be very bad, as I learned a couple years ago. Even at that though, $400+ seems just a tad excessive...


On Nov 04 10:48 AM Ron Rowland wrote:

> Trading problems with SCHB at the open this morning:
> 2 trades at $435.99
> 9 trades at $399.99
> 25 trades from $400.00 to $400.11
> 12 trades at $499.99
> Market maker lowers Ask to $27 at 9:30:09
> 1 trade at $27.00
> First trade at reasonable price of $24.75 at 9:30:13
>
> Never use “market on open” orders with ETFs (even if it is commission-free).

Nov 04 11:34 AM

[Ron Rowland:]

$400 was a bargain compared to the dozen trades at $499.99.

Since these trades were most likley done through Schwab, I wouldn't be surprised to see Schwab bust the trades. They don't need this kind of "publicity" on their new endeavor.

Nov 04 11:39 AM

[Robert Mart...:]

Ron,

You are right to call this a "watershed event".

Fees are collapsing throughout the money management business, and firms like Schwab have shifted their focus entirely to assets under management. They are ahead of the curve, and they will force their competitors to change: When Schwab offers market exposure for free, it threatens the fee structure for the entire asset management business.

This is not just about retail customers, either: High-net-worth clients also have accounts at discount brokers. Smart clients are using a "core and satellite" approach to investing. They pay pennies for beta and dollars for alpha (i.e., they pay very little for market exposure, and they pay dearly for potential alpha).

In fact, Barclays (BCS) recently launched BETA portfolios for their HNW clients, which I described here: seekingalpha.com/artic... This development, coupled with what you describe at Schwab, will continue the revolution in asset management. Clients are getting passive management for free, and are only willing to pay for tactical asset allocation and high-alpha security selection. (Fund manager selection has been all the rage for a while, but the layering of fees inherent in this business model is increasingly problematic.)

Thank you for highlighting this development at Schwab. Traditional Wall Street firms do NOT WANT ATTENTION on this development, since it erodes their profit margins. So thanks for shining the light on the implications of free ETFs.

Rob

Nov 04 01:48 PM

[a fat panda:]

Money managers need to watch this event closely. For the past 30 years, they have enjoyed increasing volume and increasing fees. I sense that they are subject to seeing both of these moving the other way.

People are going to be deleveraging for some time, and that leverage is going to be paid in part from assets and part from money diverted away from traditional savings vehicles.

I am also not confident that people will continue to pay 1.25% for a traditional mutual fund when performance is down to flat. People don't notice the 1.25% fees when asset values are growing. They do when they are falling or flat. This low-cost ETF simply exacerbates the situtation...

Nov 04 02:14 PM

[Fabien Hug:]

It good to have a new low cost opportunity. However, I doubt it will drastically change the industry. These non performing high load funds are still around even if you already much cheaper alternatives for some time now.

Nov 05 10:09 AM

[adan:]

just off hand, gotta think this is a good thing....

Nov 05 12:46 PM

[Moto:]

There's no such thing as a free lunch.

Nov 05 02:54 PM

[jmann83:]

What about the liquidity in these new ETF's? no one has commented on that? if there is very low volume the spreads will be that much higher than say the relative SPY which would take away some of the benefits of no commissions.

Nov 05 04:53 PM

[Ron Rowland:]

I expect the liquidity to improve over time. As more assets flow in and trading volume increases, liquidity will naturally follow. It's only been 3 days, but the b/a spread for SCHB was about 2 cents most of the day today. Occasionally just 1 cent, but sometimes creeping up to a nickel. 112k shares traded.

Free trading will eventually generate additional volume. Additional Volume will generate better liquidity (tighter spreads and deeper b/a).

The market makers could not maintain an orderly market for SCHB on day 1 and day 2, but today (day 3) was successful and orderly. They will get there.

Anybody expecting perfection the first week has their expectations set too high. Let's see what these things look like 6 months down the road. I will be surprised if they don't crack the top 100 ETFs in terms of daily value traded.

Nov 05 05:23 PM

[Ron Rowland:]

Moto, you are correct that there is no free lunch. For Schwab, they are giving away the trading commission in exchange for the AUM fees. It's as simple as that.

They receive no AUM fees for all the other ETF trades and stock trades they do. And heck, this might just get a few people to open up accounts at Schwab resulting in more AUM fees being generated and even some new commission fees when those new accounts trade other securities.

Nov 05 05:29 PM