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In a move with huge ramifications for the exchange-traded fund [ETF] industry, Bank of America (BAC) is eliminating brokerage-trading fees for customers with $25,000 or more in assets. The free trades will roll out in selected markets like New York and Boston this month, and across the nation by February 2007. Accounts will be allowed 30 free trades a month.

The only catch is that you need to have $25,000 in one of BoA's banking, checking or deposit accounts. One IndexUniverse.com reader pointed out that this exposes you to potentially sub-par interest rates; a full analysis showing what "free" might cost is available here.

Nonetheless, the development is big news, for two reasons. For one, the bank says as many as one-third of its 50 million banking customer will qualify for the free trades, creating a huge potential base of existing users. Nationwide, as many as 52 million households will qualify according to The Wall Street Journal (sub. req.). Secondly, as explained below, this could put additional pressure on BoA's competitors to cut costs to keep pace.

The aggressive pricing plan is designed to bring more customers into BoA’s integrated banking platform. Bank of America hopes that customers will consolidate their broad financial activities under BoA’s banner, signing up for mortgages, checking accounts, home equity loans and other services with the bank. If they do, that would more than offset the fees lost from free trading.

BoA’s decision is being driven in part by the movement by online brokerages like E*Trade (ET) into traditional banking areas like mortgages; if the brokers want to play ball, BoA says, let them try.

Impact On ETF Industry
It is hard to overstate the importance of this development to the ETF industry. Commission fees were the last remaining major argument in favor of traditional mutual funds, as compared to ETFs. Everyone agrees that ETFs – on average – offer lower expenses and better tax efficiency than traditional mutual funds. But for investors who invest relatively small amounts of money on a regular (say, making a monthly or yearly investments in a given fund), commission costs overwhelmed the other benefits.

Eliminate trading fees, however, and the balance of benefits tips strongly in favor of ETFs. If the lower fees catch on across the industry – and there is good reason to believe that they will – expect to see a strong switch of fund flows in favor of ETFs, and away from index funds.

Consider Vanguard. At Vanguard, the expense ratio [ER] on its ETF share class is typically substantially lower than the ER on its traditional fund classes. For instance, Vanguard’s Total Stock Market Index Fund (VTI) charges 19 basis points for its Investor Shares, 9 basis points for its Admiral Shares (available for investors with $100,000 or more to invest, or $50,000 for established accounts) and just 7 basis points for its ETF shares. If you eliminate trading fees, investors have no reason to pay the extra 12 basis points for the Investor shares … assuming the ETF shares trade close to net asset value (which they do).

Yes, But Will It Last?
Bank of America isn’t the first company to offer free trades, of course. Wells Fargo (WFC) offers 50 free trades per year to accounts with $250,000 or more in assets. Moreover, various start-ups have offered free trading on a limited basis in the past. But Bank of America is the first to put free trading within the reach of most investors on what appears to be a permanent basis.

There is good reason to believe that Bank of America will stick to the pricing plan, too. The company was the first major bank to eliminate fees for online banking, in 2002. At the time, everyone was skeptical of the plan, suggesting that rising costs would overwhelm the bank. Today, free online banking is the industry standard, and Bank of America has over 50 percent market share in the online bill pay space. Other banks and brokerages have surely taken note of this, and will consider it as they respond to the bank’s aggressive new brokerage pricing plan.

Retail Flows
One additional impact of this new pricing plan is that it could substantially shift the balance of fund flows into the retail space. In the early days of the ETF industry, institutional investors dominated ETF fund flows, in part because they invest in such large sums that trading fees don’t impact returns. Even today, most people estimate that ETF assets are approximately 70 percent institutional and 30 percent retail.

Retail flows, however, have grown substantially, and today represent the majority of ETF fund flows. Under this new pricing plan, the balance could easily tip even further in favor of retail.

More broadly, however, the new price plan will shift the flow of funds into ETFs … and away from index funds. If the pricing plan sticks, we could look back on today as the day that ETFs finally went mainstream, and the day when “traditional mutual funds” started to fade into the annals of financial history.

BAC 1-yr chart:

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Source: Why Bank of America's New Free Trading Will Change the Industry While Benefiting ETFs