By Paul Weisbruch
With all the media attention focused on brokers offering "commission free" trading in specific ETFs, we decided to take a look at what commission free means to institutional and individual investors.
Charles Schwab (SCHW) ETFs started this trend in late 2009 when they ventured into the ETF issuer business themselves, offering commission free trades to Schwab brokerage customers who traded these products online. These customers can be individual investors or Registered Investment Advisors (RIAs) that use Schwab as their custodian and trade through the Schwab platform. Currently, 8 Schwab ETFs can be bought or sold, commission free, on the Schwab online trading platform and the symbols are as follows: SCHF, SCHX, SCHB, SCHA, SCHE, SCHG, SCHV and SCHC.
Fidelity, which is also in the online brokerage business and caters to individual investors as well as RIAs with Fidelity as their custodian, followed suit in February of this year, and currently offers 26 ETFs to be traded commission free (25 Blackrock (BLK) iShares products and 1 Fidelity ETF: ONEQ).
Vanguard was the latest to announce they were joining the "commission free ETF" arena. Currently they offer free commissioned trades on all 46 of the Vanguard ETFs to their brokerage customers. Vanguard differs from Fidelity and Schwab as most of the trading customers who use Vanguard's brokerage platform are smaller, individual investors.
For an individual investor trading small amounts of ETFs at a time, commission rates may represent a significant portion of the overall dollar investment and negate the benefits of dollar cost averaging. While the small investor may only choose from a small portion of the ETF universe when looking for free commissions, it still may be the best economical choice to forgo selection for the lowest possible cost.
However, self-directed individuals have different needs and legal responsibilities than do Registered Investment Advisors (RIAs) and other Institutional Accounts. RIAs are charged with managing the overall goals and objectives of their clients, and have a fiduciary responsibility to act in the best interest of their customers. They generally earn fees based on the level of assets held by a client.
An exodus has been taking place for years, perhaps accelerated by the market events in 2008, which caused many disenchanted financial advisors to "go independent" from the larger wirehouse firms such as Merrill Lynch, Morgan Stanley Smith Barney (MS), Wells Fargo (WFC), etc. and create their own practices. These RIAs generally partner with a custodian firm like Fidelity, Schwab, Pershing, or TD Ameritrade (AMTD) for example, for all trading, clearing, and related brokerage activities that they previously performed within their wirehouse platforms.
Many of the RIAs we speak with have gone independent and often their reasons for moving from wirehouses include freedom from “house products.” These advisors were sometimes limited to firm research and were often urged to sell proprietary mutual funds and structured products. This inherent conflict of interest has encouraged a great many financial advisors or brokers to become fee based RIAs.
It is no wonder that advisors and clients alike appreciate the RIA model because of its transparency and lack of visible conflicts of interest. However, the new push for "free commissions on ETFs" risks regression to the old stockbroker model where a finite list of products are available for sale to clients and are pushed for dubious reasons.
Today, there are 900 plus ETFs available from 40 plus ETF issuers, and the commission free platforms only offer a small fraction of these ETFs. They are clearly skewed to only four issuers: iShares, Fidelity, Vanguard, and Schwab. As stated earlier, Vanguard is not a player in the RIA custody business, so the RIAs affected by the "commission free trades" push are generally those trading with Fidelity and Schwab.
TD Ameritrade's Ram Subramaniam was recently cited in the latest edition of Index Universe's ETFR, regarding this topic, and stated that his firm has not considered moving to a commission free ETF model. Instead, TDA believes that offering a robust ETF product spectrum to their RIA clients is of utmost importance, as opposed to relegating the choices to a finite list of hand selected products.
Are some RIAs making their investment decisions based solely on the cost of a trading commission? Judging from conversations with dozens of RIAs, we would say this does happen. For an RIA to purchase iShares or Schwab ETFs solely for “free commissions” does not serve a client who deserves to access to the full universe of ETFs, especially if better products that are more suitable for that investor exist.
Furthermore, we need to examine the size of institutional trading commissions in relation to other factors, like management fees, proper asset allocation and best trade execution. A penny commission on SPY costs the investor 0.0000935 basis points. That said, should SPY be replaced by a “commission free” ETF for no other reason than the commission rate itself?
If decisions regarding product choice and suitability are being influenced by commission, are clients aware of this? Were the 25 iShares on Fidelity's platform the only ETFs that an advisor would consider before the commission free announcement surfaced, or did the advisor alter their investment philosophy and ETF models because of these commission freebies?
Another item that RIAs captivated by the "commission free ETFs" should evaluate is trade execution itself. How and where are their ETF trades executed, and what is the cost of poor trade execution in terms of price slippage? As an RIA, are your ETF trades exposed to all available market centers for best execution? Is your order flow channeled to one market participant under a "payment for order flow" or "rebate" arrangement? What level of ETF education and trading experience do those executing your orders have? And most importantly, how are larger, sensitive block orders handled?
Expertise in trade execution, from a fiduciary standpoint, should rank higher than the commission rate for trading a given product. How good is your trader? If a trading desk that is not ETF savvy executes a large block trade in an ETF for an RIA and loses 10 cents in price slippage on the completed order, that loss equates to real basis points lost for the portfolio’s performance. Is it really "free" if that same block trade could have been executed for 3 cents in price slippage plus a 1 penny per share commission by an ETF centric trading desk?
Implicit commissions may not appear on paper but are very real and can be very detrimental to investors' returns over time. Some market participants and trading desks do not understand the pricing nuances that are unique to ETFs, like trying to fill orders with large spreads, adhering to NAVs, and understanding the relationship between ETFs and their underlying securities.
These "free commission" trades may not be free at all if the overall execution process costs the advisor and the investors money through poor trade execution. That said, those RIAs who chose to relegate their ETF usage to those offered on a commission free basis owe it to their clients to investigate the quality of their trade execution against stated metrics on a consistent basis, because simply calling something "free" does not necessarily make it so.
We spoke with Noah Hamman, CEO of the ETF issuer AdvisorShares, and he offered insight on these topics:
We believe commissions are the least important factor when making the investment selection. These firms are giving away the least valuable aspect, and unfortunately this can impact an Advisor's decision on the more important factors. We rank the factors as follows:
1) Asset Allocation
2) Investment Selection
3) Trade Execution - Spreads
By far, the most important decision the RIA will make for their client is the appropriate asset allocation for their client. This can have the biggest impact on the targeted performance. Next is the actual selection of the underlying investments for the asset allocation. This is an important decision, as the current beta ETFs include capitalization weighted, fundamentally weighted and equal weighted beta ETFs. The selection process can easily impact returns by + or - 2%.Fortunately, RIAs now have the option of considering alpha ETFs (Active ETFs) as part of this decision as well. This reinforces the need to work with a custodian or broker that provides the RIA the broadest selection of ETFs. This is when trade execution becomes important, use of the indicative value (for most ETFs), limit and stop limit orders, and a good execution desk, can also have a big impact on the costs. In fact, this process can in some cases, improve performance by some or all of the trades at an improved price to the ETFs indicative value. Commissions are important, but the least impact on the overall performance and expected returns.
Commission free ETFs have a place for the individual investor who purchase small lots and judge cost versus selection (or even asset allocation) for themselves. However, most RIAs consider themselves to be independent fiduciaries and have built their practice based on flexibility and choice. The entire ETF universe should be available to their clients.
RIAs employing ETFs in their clients' portfolios are moving in the right direction, but screening out high quality products and limiting investment choices because of commissions is a shortsighted step in the opposite direction. It is our hope that most RIAs will continue to be free thinkers, choosing the investment products that most aptly fit their clients' portfolios. If your asset allocation is the jockey and investment selection the horse, making portfolio decisions based on commissions is like betting on the saddle.
Disclosure: No positions