Commentary

I have to admit, Schwab's Nov. 2 announcement that it would not charge trading commissions to clients purchasing Schwab ETFs on its online trading platforms was a bit of a shock to me.

I have long theorized that it was only a matter of time until one trading platform or discount brokerage launched its own line of ETFs and used subsidized trading costs to fuel asset growth. I had initially figured that said company would offer discounted trades--say, $3 a trade instead of $12 a trade. It was hard for me to see a scenario where a for-profit group of firms would offer its funds with a $0 trading cost. So, it was a huge surprise when Schwab not only came out with what can only be described as ultracheap offerings from an expense-ratio perspective but also dropped trading costs to $0.

Overall, this is an incredibly investor-friendly move. In fact, I will go so far as to say this is one of the most investor-friendly actions by a fund company ever. Is it at the same level as Jack Bogle founding Vanguard or the rise of discount brokerage platforms? Probably not, but it is up there. I say it is one of the top-five most investor-friendly moves by a fund company or financial company, but others can feel free to disagree.

What's in It for Chuck?
Now, let's not kid ourselves and think that Schwab simply did this out of the goodness of its heart. Last I checked, it was a publicly traded company and not the Salvation Army. Of course, this will help Schwab grow assets in its funds--jump-starting their liquidity and removing one of the major humps that all new ETFs face.

From a business perspective, Schwab was staring down a world where advisors and investors alike were using low-cost ETFs to circumvent the wholesaler costs charged by mutual fund supermarkets. Schwab's One Source platform is among the largest of these supermarkets, which means that it had a front-row seat to witness the phenomenon. Worse, as more and more advisors and investors adopted passive management strategies, Schwab was likely to get hit with a double whammy of losing fees from the wholesale business, while not making it up in trading commission. You see, in passive management, investors would buy their ETFs, set their allocations, and maybe rebalance once or twice a year. So, in theory, Schwab would gain assets, but the ETF providers would be the ones making all of the money. Given all of the baby boomer money that is set to roll out of tax-deferred accounts (IRAs and 401(k)s), Schwab needed to position itself better to deal with the needs of both its Registered Investment Advisor client-base and self-directed individual investors. All of them report, in any survey that I've seen, that they plan on using ETFs more and more in their portfolios.

In addition to alleviating the situation mentioned above, Schwab can attract new clients and is providing a much appreciated service to existing ones. With this the firm can continue to gather assets and sell other services such as cash deposits, margin accounts, and trading costs on other non-Schwab products, be they ETFs, mutual funds, or individual securities.

Even after laying out all of the reasons Schwab may have done this for itself, I say, "So what?!" Investors are the big winners here. If Schwab is willing to split the economic rents from providing low-cost, transparent, liquid ETFs to investors by offering those funds free of transaction costs, then I honestly don't care why it did it.

Teaser Rate?
The biggest concern for most people out there is that this is a bait-and-switch teaser rate to attract assets in the short-run. We had some representatives from Schwab come in to Morningstar HQ to talk about their ETF offerings and their strategy. I asked them point-blank if this was a teaser rate. Their response (and I am paraphrasing) was that this was absolutely not a teaser rate and that Schwab was committed to keeping these products commission-free for the long haul. I then asked if that was in writing somewhere, and I received an answer that I interpreted as it was written down somewhere ... but don't consider it legally binding. So, I will tell the folks at Schwab this: As long as your ETFs remain commission-free to your clients, then I will continue to describe this as one of the most investor-friendly moves ever. Because you reserve the right, so do I. In the end, it most likely won't even matter if it wanted to rescind it because ...

The Competitive Response
People in the financial world must be livid with this move. ETF providers are beside themselves because, with the possible exception of Vanguard, they don't have a trading platform with which to waive fees. They are all looking to advisors and individual investors to fuel their assets-under-management growth over the next 10 years. Other discount brokerages are mad because they had planned on trading costs from ETFs to be a huge driver of future revenue. Wirehouse platforms are ticked because this is just another reason for their best advisors to go independent on them, and they had thought ETFs would be the best of both worlds for themselves (wrap fee plus trading commissions). The traditional fund companies can't like the fact that, without commissions, you lose that transaction-cost friction that kept ETFs out of 401(k) plans or made them unsuitable for dollar-cost averaging strategies.

Game theory would tell us that this move cannot stand unmatched. Really, that is what leads me to call this a "shot heard around the world" type of event. The ETF providers can't sit by and watch this upstart new entrant gather the assets that they've been counting on--especially with the price BlackRock paid for iShares/BGI. The other discount brokerages won't be able to let Schwab woo their clients with a promise to remove the one thing that investors and traders alike despise: trading costs. Frankly, I'm not really sure what the wirehouse firms can do about this.

So, what will they all do? The ETF providers are going to need to either build trading platforms or find some partners. Finding partners would most likely be the more cost-effective move in the long-run. Imagining a BlackRock and E*Trade merger or partnership is not out of the question. The bigger discount brokerages and investing platforms are going to need to either develop their own competing ETF products or similarly find partners to split the costs with. I think the bigger ones with larger RIA clearing operations like TD Ameritrade or Fidelity are more likely to develop their own products. Short of banning the products from their platforms, I'm not sure how wirehouse firms can respond. I would advise them not to do that, as it would only tick off their clients and advisors. If I were them, I would match the $0 commissions and be content with the wrap fee and other service fees that are charged. In fact, wirehouses could adopt that for all ETFs and perhaps stem the tide of asset and advisor outflows.

Overall, ETFs are a commodity product--especially if they track passive indexes. That may sound strange coming from someone who likes ETFs as much as I do, but that is exactly why I like them. In commodity products, the lowest cost wins; that's just Econ 101. This kind of competitive price pressure will invariably push the cost of investing down for all levels of participants investing in ETFs and funds in general. Even if Schwab wanted to rescind this offer three years down the road, it won't matter. If its competitors match it, then it won't really have the choice. To do so would invite the same outflows that its competitors now stand to face with the launch of these new ETFs.

Challenges for Chuck
For all the positives this brings to investors, it won't matter much if Schwab can't execute a successful investing experience for its clients. That means these funds have to perform as advertised, and, more importantly, the market makers and authorized participants (the folks responsible for arbitraging ETF premiums and discounts) have to do their part. If investors get bad trade execution or the funds' performance lags competing offerings, then this will be all for naught. While there may be some stumbles early on, I don't think this is a major long-term concern. The Schwab team has hired some pretty experienced and well-known folks from competitors and the exchanges to make sure that this operation runs as smoothly as possible. That said, the standards are pretty high these days in terms of both execution and performance, so the margin of error is pretty slim.

Put One on the Board for Investors
Combine the value added for Schwab clients with what the most likely competitive response will be from the industry as a whole, and investors are the real beneficiaries here. This move has all the makings of redefining ETF investing for the smaller investor and the potential to redefine fund investing in general.

I have a saying, "When fund companies compete, the investor wins." This week, the investor won and won big.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.