Commentary

Another giant in the asset-management industry has moved into the ETF market. On Oct. 27, 2009, leading U.S. brokerage firm Charles Schwab filed an updated prospectus for its eight forthcoming ETFs. With the details now ironed out, the funds are ready to commence trading and should launch shortly. Charles Schwab Investment Management, which serves as the advisor for all Schwab and Laudus Funds and has more than $214 billion in assets under management, will serve as the investment advisor for the new ETFs. It's worth noting that, while new to ETFs, Schwab is a veteran indexer with a stable of passively managed index mutual funds offering rock-bottom pricing.

There's nothing fancy about the new Schwab ETFs; the firm is launching five domestic-equity funds tracking Dow Jones indexes and three international-equity funds tracking FTSE indexes. With a plethora of options already on the market, Schwab is set to compete head-on with industry heavyweights iShares, SSgA, and Vanguard in the quest to accumulate assets. On this front, it will be interesting to see how Schwab looks to lean on its expansive network of financial advisors for marketing support. With little differentiation among ETFs offering similar exposures, Schwab's strong brand name and its product pricing will be critical to the firm's success in the budding ETF industry.

The new Schwab ETFs are set to come out of the gate strong, in terms of expenses. Schwab U.S. Broad Market ETF, a portfolio of roughly 2,500 domestically traded stocks, and Schwab U.S. Large-Cap ETF, which holds about 750 large-cap stocks, will both launch with net annual expense ratios of just 0.08%. Vanguard Total Stock Market ETF, which tracks the MSCI US Broad Market Index containing more than 3,300 stocks and levies 0.09% in net annual expenses, was formerly the cheapest in its peer group prior to Schwab's debut. Schwab's broad market fund also undercuts SPDR DJ Total Market, which charges 0.20%, by a healthy margin.

Schwab U.S. Broad Market will certainly be a hit if it can chip away at the market shares of SPDRs and iShares S&P 500. SPY and IVV both levy 0.09% expense ratios and combined hold more than $90 billion ($70 billion of which is in SPY). Time will tell if Schwab's 1 basis point cost advantage versus SPY and IVV will be enough to un-seed some of that capital. In any case, at 8 basis points per annum, U.S. Large Cap's fees will clock in at less than half the majority of large-cap ETFs, some of which levy fees as high as 0.50%.

Rounding out the domestic-equity lineup will be Schwab U.S. Large-Cap Growth ETF, Schwab U.S. Large-Cap Value ETF, and Schwab U.S. Small-Cap ETF. These three funds are slated to launch with expense ratios of 0.15%. This puts the new Schwab funds right on par with Vanguard Growth ETF, Vanguard Value ETF, and Vanguard Small Cap ETF, each of which also charges 0.15% per annum. The new Schwab ETFs will be cheaper than comparable offerings from iShares and SSgA.

For example, iShares Russell 1000 Growth and iShares Russell 1000 Value, which combined have more than $18 billion in assets, both charge 0.20% expense ratios. SPDR DJ Wilshire Large Cap Growth and SPDR DJ Wilshire Large Cap Value also charge 0.20% and have almost $300 million in assets. Schwab U.S. Small-Cap should be competitive at 15 basis points, considering iShares S&P SmallCap 600 and SPDR Dow Jones Small Cap charge expense ratios of 20 and 25 basis points, respectively.

Schwab's international-equity ETFs are set to make a splash, in our view, as they should enjoy the low-cost leadership position from the get-go. Schwab International Equity ETF, which will track the FTSE Developed ex-US Index, will charge only 0.15% per annum, versus the 0.34% charged by iShares MSCI EAFE (which has about $35 billion in assets). Similar products from SSgA include SPDR MSCI ACWI (ex-US) and SPDR S&P World ex-US, which levy expense ratios of 0.35% and 0.60%, respectively. Schwab International Equity has promising prospects, in our view, as it will debut with a cheaper expense ratio than the perennial cost leader; Vanguard FTSE All-World ex-US charges 0.25% per annum and has nearly $7 billion in total assets.

At 35 basis points, Schwab will also offer the lowest-cost international small-cap option when Schwab International Small-Cap Equity ETF launches. Close behind, in terms of costs, will be Vanguard FTSE All-World ex-US SmallCap at 38 basis points, which debuted earlier this year on April 2 and has already amassed more than $325 million in assets. Other comparable alternatives to International Small-Cap Equity include iShares FTSE Developed Small Cap ex-North America and SPDR S&P International Small Cap, which charge net annual expenses of 50 and 60 basis points, respectively.

The last new Schwab ETF set to launch will be Schwab Emerging Markets Equity ETF. As revealed in the year-to-date ETF flow data, this has certainly been a hot spot in the market this year. Emerging Markets Equity, which will charge a 0.35% expense ratio, faces stiff competition from Vanguard Emerging Markets ($14 billion in assets) and iShares MSCI Emerging Markets ($34 billion in assets). VWO and EEM have attracted roughly $7 billion in new assets in the year-to-date period through September month-end. The new Schwab ETF will be well positioned to benefit from investors' heightened interest in emerging markets. Schwab Emerging Markets Equity will charge slightly more than VWO's 0.27% expense ratio but will come in well below the 0.74% levied by EEM.

Investors should welcome Schwab's entrance into the ETF universe. While there's nothing earth-shattering about the exposures offered by the new Schwab ETFs, the relatively low expenses that Schwab plans to charge should at least keep the big boys in the industry honest. PIMCO, which undercut rivals' pricing on its plain-vanilla fixed-income ETFs, has enjoyed success with its recent foray into ETFs. It's foreseeable that Schwab could enjoy similar success on the back of its strong brand and low prices. Moreover, we're anxious to see if the investment advisor might be able to offer enhanced tax efficiency or tracking results through synergies between the new ETFs and its existing index mutual funds. While Vanguard has patented the "ETF as a separate share class" model, we wouldn't be surprised to see crafty portfolio managers attempt to find similar advantages.

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John Gabriel does not own shares in any of the securities mentioned above.

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.