Schwab: Big News for ETFs?

Nov. 8.09 | About: Schwab U.S. (SCHB)

By Matt Hougan

Schwab’s new ETFs solve one critical problem in the ETF market, but they won’t take over the world. At least not for a while.

I’ve been thinking about the Schwab ETF launch all week, trying to figure out if it’s a game-changing event or an overblown bit of marketing. I think it’s a bit of both.

The big news, of course, is that Schwab is entering the ETF market and breaking new ground on fees. It has launched four ETFs that offer the lowest expense ratios in the world: As low as 0.08 percent for U.S. broad market exposure. The new Schwab Total Market ETF (NYSEARCA:SCHB) and Schwab Large Cap Equity ETF (NYSEARCA:SCHX) are now the lowest-cost mutual funds available to retail investors.

What’s more, Schwab is offering zero commissions for Schwab customers who buy or sell the ETFs.

That’s a big deal. Commissions are a huge hurdle for retail investors looking to allocate to ETFs. A retail investor placing $1,000 at a time should think carefully before buying ETFs: Even low commissions of $10/trade can eat up returns. A $10 commission on a $1,000 purchase is equivalent to paying a 1 percent load. For most investors, that cost can overwhelm the advantages ETFs offer in terms of low expense ratios and tax efficiency.

I’ve been writing about the importance of eliminating this commission hurdle for years, and I applaud Schwab for doing it.

(Of course, Schwab isn’t the first to eliminate commissions: Zecco offers zero commission trading, and both Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC) will let you trade for free if you keep $25,000 in their money market funds. But Schwab is a well-established brand with a huge client base and a built-in distribution system. For it to offer zero commission trading with no major “catch” is a big deal.)

So it’s with a bit of hesitation that I say that, at least out of the gate, I do not expect these ETFs to gain a huge amount of assets.

We’ve seen firms like Fidelity and E*Trade (NASDAQ:ETFC) try to swoop into the indexing world before with ultra-low-cost mutual funds, only to fail. I’m not sure retail investors brook much difference between expense ratios of 8 basis points and 10 basis points. At a certain point, for retail investors, you end up talking small numbers.

Those differences in expense ratios can be overwhelmed by factors like how well the funds track their benchmarks and whether the sponsoring firms arrogate securities-lending revenues on the portfolios. Schwab does have the skills to run excellent index funds, but it will have to prove itself as an operator of these ETFs for a while before people buy in en masse.

For larger investors, the critical question is how these funds will trade.

There will be huge swaths of ETF investors who will not go near these funds until they’ve established a large asset base and can provide the kind of limitless instant liquidity offered by funds like the S&P 500 (NYSEARCA:SPY): Hedge funds, other mutual funds, day traders and the like will be willing to pay commissions to ensure access to the deep pools of liquidity these funds provide. So far, the Schwab ETFs have been trading at decent spreads. But larger investors may still be concerned about the costs and time involved in moving large block trades near fair value. There are ways to do it with any ETF, but it will be harder in SCHX than it is in SPY for some time.

At least initially, Schwab ETF assets will be driven more by long-term buy-and-hold investors. It’s ironic given that the funds’ key selling point is “free trading,” but I think that’s true. And the simple truth is that buy-and-hold assets grow slower than fast-money trading assets. So look for a slow build on the Schwab ETFs rather than any runaway asset train.

There is one thing, however, that’s for certain: Schwab’s huge push to market these ETFs to its clients and to the retail investing public will drive increased awareness of the ETFs in general. In that sense, I think the Schwab ETFs absolutely will help drive the next major leap in growth for the ETF assets.

And over time, I expect the Schwab funds will gain significant assets. It just won’t happen overnight.

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