Charles Schwab Could Disrupt The ETF Industry

Summary

• Charles Schwab contemplates the possibility of offering fractional shares.
• Fidelity offers investors a way to buy an entire portfolio with a single click of a button.
• Put those two tools together, and you could potentially disrupt the entire ETF industry.

There is a recent MarketWatch article about Charles Schwab (NYSE:SCHW), which publicly contemplated offering fractional shares of stocks and ETFs. The idea, as I understand it, would allow younger investors to purchase $100 worth of an ETF such as the SPDR S&P 500 ETF (SPY) that currently trades at close to $300 per share. Sounds simple enough, but wait! There's more.

A Seeking Alpha reader going under the handle CHJ73 recently sent me an email pointing out a feature at Fidelity Investments that I hadn't previously heard of, "Basket Trading." The way that "basket trading" works is you list up to 50 shares of stock that you want to buy with a single click of a button. And then you click the button. Simple. Convenient. And it's been around for a while (back when Fidelity charged for trades, basket trading seems to have been a rather generous cash cow for brokers like Fidelity). Nothing new there.

But stop and think about this for a moment. Basket trading seems quite similar to buying a 50 stock ETF, doesn't it? Only, there are a few salient differences. The big difference is that with basket trades, you cut out the middleman by owning the underlying shares of stock directly, rather than through an ETF. Why might an investor want to do this? For starters, you avoid ETF management fees if you don't own ETFs. Trading is now free at places like Fidelity, so it costs nothing to execute the strategy. And baskets are entirely transparent and customizable - unlike an ETF, which may own shares of companies you'd rather not own and subject to investment selection criteria you might not completely understand or even know about since many of the indexes that some ETFs track are proprietary and secretive.

I'm a big fan of passive, long-term investing. I aspire to generate zero portfolio turnover, which leaves me feeling frustrated when I watch the ETFs I own routinely trading into and out of positions. But once you buy a basket of stocks, there is no reason compelling you to sell anything, ever. Could I ever simply copy the holdings of those ETFs every time I want to invest more money into an equivalent basket of securities, keep the shares I already own, and create a zero turnover version of the ETF?

For free?

With a little digging that a friend of mine did last week, we found that the problem with basket trading is that you can only buy integer quantities of shares. That's where Charles Schwab's idea starts to look particularly interesting, because if you could place basket trades of fractional shares, there is no reason why you couldn't create a static portfolio of stocks, or an evolving portfolio based on your own customized investment criteria, and add to it as often, and with as little money, as you like.

For free.

With as much (or as little) turnover as you want.

With 100% transparency as to what you own, in what proportions, and subject to whichever investment selection criteria you desire.

And did I mention, for free?

It's hard for me to see any reason to purchase ETFs in a world where you can get free trading of personally tailored baskets of fractional shares. Perhaps a product such as Fidelity's basket trades combined with Charles Schwab's fractional share idea could have an impact on the ETF industry similar in scope to the impact that ETFs had on the mutual fund industry. Would a product like that spell doom for ETF sponsors like BlackRock (BLK)? I don't know, but I doubt it. On the contrary, I suspect that customized basket trade investing would create new opportunities to generate profits (at least for the more nimble and forward-thinking ETF sponsors and brokerages). Maybe baskets of fractional shares would open new avenues for sponsors to sell research, newsletters, preset model portfolios, or robo-advice and robo-trading. Cutting out the middleman is often a great opportunity for savvy businesses to introduce new forms of higher margin services. It is not yet clear whether basket trading and fractional shares ever will come together, but if so, investors could potentially benefit from low (or no) cost products that offer far more transparency and control than ETF structures generally allow. And some players in the investment industry will certainly end up devouring the lunches of other players who were too slow to adapt.

Disclosure: I am/we are long BLK, SCHW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.