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U.S. broker Charles Schwab’s launch this week of 8 new exchange traded funds (ETFs) could be a watershed event for providers and users of ETFs and mutual funds. What’s remarkable is that Schwab has fixed its management expense ratios (MERs) even lower than the Vanguard ETFs and is allowing its ETFs to be bought and sold commission-free on a permanent basis through a Schwab account. The brokerage's current and forthcoming ETFs will be the lowest-cost vehicles around for gaining exposure to key asset classes (hat tip to Preet Banerjee for bringing this to my attention by email).

Commissions have been one of the few drawbacks to ETFs because they can chew up accounts of investors who prefer to invest through dollar-cost averaging. This was once an area where mutual funds had an edge, but no more at Schwab and other brokerages who may follow suit (Preet wonders if this is what the Bank of Montreal — BMO — has in mind with its ETFs). So mutual-fund executives could be on the Maalox now. And so too might executives at ETF companies with no brokerage arms.

But how is it possible for Schwab to charge no commissions and MERs as low as 0.08%? In a previous post, I thought it would be possible for ETFs to get their MER costs down lower, even all the way to 0%, by using fees earned from lending out securities to cover operating costs. This seemed less fanciful a speculation when a few months later, as Preet noted in a blog post, some ETFs had emerged in Europe with 0% MERs.

So that would be my guess in this case. Schwab is diverting the revenues from its securities lending operations to cover off its operating costs. With sufficient volumes of business, they could still turn a profit while giving investors big breaks on fees. This is what Tom Lydon of ETF Trends thinks it might be too.

Indeed, it’s conceivable, as competition heats up, for MERs on ETFs such as Schwab’s to move to the 0% mark. It may not happen overnight or not at all, but there is a potential. Also, one wonders if established ETF families like Barclays Global, which currently pocket 50% or more of the securities-lending fees for themselves, might now feel pressured to switch their cut toward lowering MERs. Could they even possibly pay investors to buy their ETFs — or otherwise reimburse their trading commissions?

Source: Schwab's New ETFs: A Watershed Event