By Matt Hougan
Dave Nadig's argument about Fidelity's new free trading offer is clever, insightful, well written… and wrong.
At least, it is for the majority of investors.
In case you missed Dave's blog on Fidelity, it's available here. In essence, Dave argues that Fidelity's move to offer free trading in 25 iShares ETFs is—despite appearances—bad for long-term investors, because it commingles the cost of trading ETFs with the cost of actually running the fund.
It's a sound academic argument. One of the beautiful things about ETFs is that they work well for traders and for investors. When traders move in and out of traditional mutual funds, the funds are forced to buy and sell securities to facilitate that cash flow. That harms long-term shareholders, who bear the costs of commissions and spreads. That's why many mutual funds have short-term redemption fees.
In ETFs, small-scale trading activity does not engender costs to long-term shareholders because it takes place on an exchange. For large transactions, ETFs that use in-kind creations and redemptions (which is to say most ETFs) are protected as well. It's part of the reason ETFs are inherently "fairer" than mutual funds: The costs (as well as the tax consequences) of buying and selling shares is borne by the person who does the buying and selling, not by other shareholders.
Until, according to Dave, now. Dave assumes (correctly, I imagine) that BlackRock (NYSE:BLK) is paying Fidelity a fee to subsidize the free trading offer:
"Whatever BlackRock is paying Fidelity to offset trading costs is money that could otherwise be spent to the benefit of long-term investors."
The problem with that argument is twofold: First, it's hypothetical and only looks at one facet of the fee question; second, and more importantly, it overlooks the huge class of investors that this deal helps.
On the first point: There is no reason to believe that BlackRock fees will rise or even decline more slowly under this deal. Price competition is alive and well in the ETF industry. My sense is that the money BlackRock is spending on this effort is considered a "sales & marketing" effort, and if it weren't spending money on this, it would be spending money on advertisements in the Wall Street Journal, Barron's, etc.
The second point is more fundamental. While your argument makes theoretical sense, it ignores the huge class of investors who are excluded from ETFs today by the burden of commissions. For the individual investor with $1,000 or $10,000 or even $50,000 to invest in a portfolio of ETFs, commissions are significant. Many of these investors (rightfully) stay out of ETFs because the commissions would eat them alive. Others, I'm sure, follow suboptimal rebalancing schedules for the same reason.
The Fidelity offering, like the Schwab (NYSE:SCHW) offering before it, brings these investors into the fold, inviting them to enjoy the benefits ETFs offer, including intraday liquidity, better transparency, inherently lower costs (even with the Fidelity kickback) and vastly superior tax-efficiency.
Of course, you have to look at the all-in costs of your investment; for certain funds, you may be better off paying a commission even if you're a small-scale investor. But for others, these offerings open the door.
So yes, on a theoretical basis and for large, wealthy investors, the Fidelity deal is a bad shake. But for the rest of us, it's good news indeed.