By Dave Nadig
On examination, this silk purse looks more to me like a sow's ear.
We’re fond of thinking we’re the smartest guys in the room, so it’s always good when someone knocks us down a peg. Back in November, when Schwab (SCHW) launched its commission-free ETFs, Matt Hougan and I were both skeptical on the podcast. We weren’t skeptical that they’d be successful, and indeed, with $556 million in assets as of today, they’ve clearly found an audience.
Instead, we were skeptical about whether Schwab's move was a harbinger or an outlier. Ultimately, we concluded that Schwab was in a unique position: They didn't need to make money on trading their ETFs, because they could just profit from the management fees. Other brokerage firms—like Fidelity or E*Trade (ETFC)—would have to sacrifice real trading revenues to strike such a deal with a big ETF provider.
The problem is, as it so often is, cash. Such deals aren't unknown. The traditional mutual fund industry was busted apart by Schwab's "OneSource" program back in 1992, which let Schwab customers trade a select list of no-load mutual funds without transaction costs. During the '90s, the program became a dominant feature of the mutual fund landscape—no fund company could hope to compete without either a sales commission or a contract with Schwab.
And those contracts weren't (and aren't) cheap. Fund companies pay Schwab up to 40 basis points to be part of that no-transaction fee business.
40 basis points!
That's more than the total expense ratio of most core ETF holdings, and certainly more than all of a few of the 25 ETFs featured under this deal with Schwab (with a few notable exceptions, like the iShares MSCI Emerging Markets (NYSEArca: EEM) at 72 basis points).
So what is the deal here? Well, it's fairly certain that money's changing hands, and that money is coming directly out of the BlackRock coffers and into the hands of Fidelity. But on what terms?
My guess is that it's a similar deal to the OneSource program—a flat basis point deal. The numbers would have to be much, much smaller, but it's the only situation that makes sense. It's not the only option—Fidelity could believe that offering the core iShares products on a privileged basis will drive assets into other products and trading in other ETFs, but I doubt they’re feeling so generous with their client base as to offer it as a wash.
They could be asking iShares for trading coverage—a few dollars per trade—but that would put perverse incentives in place, where Fidelity would want trading volume and iShares would want assets under management.
Finally, there could be some sort of alternative deal—a flat fee perhaps. But given that the deal has been confirmed as lasting at least three years, everyone concerned has to be looking at the upside, and in this case, upside means assets.
For this perspective, it’s basis points for sure. But how many? 13F filings aren’t really that helpful here, as all the mom-and-pop holders inside Schwab and Fidelity aren’t counted in one clean line item. But it is fair to say that Fidelity probably has a lot of money sitting in iShares ETFs, and this deal represents a reasonably large new source of income for them.
That new revenue stream is coming online at an important time, because in case you missed it, there’s a flat-out price war being waged among discount brokers right now. While “25 Commission-Free iShares” is what made the headlines, the more important news may actually be that Fidelity is lowering its commissions to $7.95 on everything else. That’s the low mark among the big retail discount brokers, and it’s a blow that’s going to hurt the already-hurting discount brokerage business. Schwab, for its part, just reported its worst quarter in recent memory, with negative revenue growth of -18% year-over-year.
While the price war is good news if you’re a hyperactive trader, I believe it’s actually bad news for long-term investors. Whatever BlackRock (BLK) is paying Fidelity to offset trading costs is money that could otherwise be spent to the benefit of long-term investors. One of the great things about ETFs is that they cleanly segregate trading and investing costs. Unlike mutual funds, ETF investors don’t—until now—suffer any ill effects for their funds being heavily traded.
This move to have trading costs essentially covered by ETF expense ratios just tosses mud on what—up until now—had been a very, very clean lens.