The Schwab ETF Launch: More Important than You Think

| About: SPDR S&P (SPY)

By Dave Nadig

Matt Hougan may think it’s all about Zecco. I think it’s all about advisers.

Zecco? Really Matt? Honestly, for investors who are holding big accounts at Zecco, Schwab (NYSE:SCHW) isn’t likely to be an issue in any case. Zecco, for those who don’t know the firm, is a super-low-discount broker, offering everything from bargain basement foreign exchange trading to $5 options. A few ETFs are unlikely to even be on the radar of Zecco customers.

I think the real target for Schwab’s new ETFs is the money Schwab’s existing customers have in ETFs.

Schwab’s huge. They custody $1.3 trillion for their 5.3 million customers, and process over 300,000 trades each and every day. Perhaps most importantly, Schwab acts as the back end for over 6,000 independent advisers in their adviser services business.

It’s a mistake to think that Schwab, as a broker, is in the transaction business. Fundamentally, they’re in the banking business. Schwab makes 35-40 percent of its revenue, quarter in and quarter out, by loaning money to its customers on margin and by investing cash balances for better rates than they have to pay through in margin balances. Another 25 percent of their revenue comes just from investment management fees (with another 10 percent from the annual fees mutual funds pay to be in their OneSource program). Commissionable transactions make up just 20 percent of their revenue stream.

Now, you and I both know that exchange-traded funds are the future. I can easily see a world 5-10 years from now when ETFs have become such a dominant force that direct mutual fund accounts are seen as a quaint throwback for folks who just can’t give up their opaque active management addiction. But this rise in ETFs does absolutely nothing for Schwab’s bottom line. They’re facing a terrible margin environment in their biggest revenue line, and the death of the mutual fund industry for that other 35 percent. Every Schwab client who moves away from mutual funds and into ETFs is a flat-out money loser for them, now and forever.

Schwab’s move is a tacit acknowledgment that this is where the money is. Ten basis points may not seem like much, but for a company pushing trillions around, a billion here and there is big business. Schwab, like most asset management firms, has been suffering from declining asset balances. This move aims to recapture a large portion of existing client assets through marketing, low fees, and, yes, no transaction costs.

Why does the transaction cost matter? Because it means a financial adviser can start dribbling her client’s cash back into the market without showing any costs for the transaction. The more I talk to advisers, the more I’m convinced that those $15 transaction costs have a deleterious effect on their client relations out of proportion―many zeros out of proportion―to their actual impact on their clients’ wealth.

And how big could the Schwab move be? Well, let’s assume for a moment that Schwab has 20 percent of all ETF assets under custody. That’s not an unreasonable guess, since they have about 20 percent of the retail market (I’m ignoring the large institutional presence in ETFs for this, I admit). This would mean that—just to pick two-bit ETFs—Schwab is holding some $20 billion in the SPDR S&P 500 (NYSEARCA:SPY) and iShares S&P 500 (NYSEARCA:IVV) ETFs. I think it’s entirely reasonable that this move could recapture at least half that position, putting $10 billion in Schwab’s Large-Cap ETF (NYSEARCA:SCHX). If you run the same math on the rest of the large-cap ETFs, and the ETFs in the other seven asset classes Schwab’s competing in, I think it’s in the realm of possibility that they’ll have gathered $100 billion in assets by the end of next year, solely from poaching off existing ETF assets in existing Schwab accounts.

And this, of course, is only a fraction of their real target market.

No, Schwab won’t be grabbing Zecco customers by the handful. They’ll do just fine getting a big fat slice of their own customers’ pie.

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