What to Make of Schwab's Commission-Free ETF Strategy

by: Sam Subramanian
Charles Schwab (NYSE:SCHW) has recently cut the commission rates for online trades of equities and non-Schwab exchange-traded funds regardless of the retail investor’s account size and trading frequency. Schwab’s base commission rate is lower than those of E*Trade (NASDAQ:ETFC), Fidelity and TD Ameritrade (NASDAQ:AMTD). Additionally, Schwab is not charging commission on trades of the eight ETFs the firm has recently launched.
Motives behind Schwab’s Moves
Clearly, Schwab is making these moves to gain market share from the competition. Schwab likely expects trading volumes stand to stay low or decline. By cutting commission rates and offering commission-free trades on Schwab ETFs, the online broker is seeking to attract new assets and encourage existing clients to trade more frequently.
Schwab has scored some success with its in-house ETFs. In all, the Schwab ETFs have garnered roughly $350 million in assets since issuing the first batch of four ETFs in November 2009. The Schwab ETFs have expense ratios that are lower than those of BlackRock (NYSE:BLK) iShares and SPDRs and are generally comparable with Vanguard ETFs. The Schwab ETFs generally trade with high liquidity and low spreads.
Competitors’ Probable Counter Moves
The online brokerage industry is highly competitive. Brokers realize they have to provide competitive pricing to forestall their customers from switching to a competitor. Schwab’s recent move is reminiscent of price wars in the years past. It is highly likely that one of Schwab’s competitors will respond by cutting commission rates. Brokers are likely to step up ad spending in a bid to acquire new customers.
Should You Invest in Public Online Stock Trading Companies?
Online brokers have enjoyed relatively stable pricing over the last four years. In an earlier article ‘Online Stock Trading Companies: Buy, Sell, or Hold’ published on October 30, I suggested that the fortunes of online stock trading companies are likely to improve in 2010 and that investors can nibble and build their positions in Schwab and Ameritrade. Since that time, shares of Schwab are up 11% while shares of Ameritrade are down 2%. Given changes in the industry landscape since then, I believe shares of online brokers should now be avoided.
Schwab’s actions, however, threaten to stress the industry at a time when it is facing some headwinds. With the Fed continuing to maintain short-term interest rates near zero, brokerages are waiving fees on money market funds to show some meager income to their clients on such accounts.
Earnings reported by Ameritrade and Schwab yesterday are hardly inspiring. Ameritrade and Schwab have reported sequential declines in average daily trades of about 8% and 3%, respectively. This combined with rising expenses crimped margins. Ameritrade’s operating margin contracted by 140 basis points from the previous quarter while Schwab’s pre-tax profit margin contracted 470 basis points.
Escalating competition in online trading can pressure margins further and impair the profitability of brokerage firms.
Disclosure: I do not have long or short positions in any of the securities discussed.