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10 reasons why Schwab's move into ETFs may be an even bigger deal than it appears

Big broker's move could be precursor to ETF equivalent of OneSource

Wednesday, November 4, 2009 – 8:32 PM by Brooke Southall
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Charles Schwab & Co. thundered into the exchange traded fund business in double-barreled fashion. The San Francisco-based broker announced this week that it will not only have its own ETFs but you can buy them for free. The ETF industry has grown so accustomed to a certain hierarchy that this news is not easy to assimilate. Is this a major player asserting itself or too little too late by a latecomer to the ETF game? The former scenario is a distinct possibility: “Years from now this could be the shot heard around the world,” says Scott Burns, the director of ETF analysis for Morningstar in an interview published in SmartMoney today. To see whether indeed this is world-beating move, I communicated with Tom Lydon, an RIA and editor of ETF Trends and Schwab itself and they provided important thoughts and information. I also reached out to Barclays Global Investors and Powershares and both declined to discuss the Schwab ETF matter.

Here is some information that may bring what Schwab is doing into better perspective.

1.) Schwab launched four exchange traded funds this week that track the Dow Jones U.S. Broad Stock Market Index, the Dow Jones U.S. Large-Cap Total Stock Market Index, the Dow Jones U.S. Small-Cap Total Stock Market Index and the FTSE Developed ex-US Index. Schwab also pre-announced four more ETFs that will be coming down the pike in December.

2.) For online trades of ETFs made by its brokerage customers, Schwab is not only charging no commissions, it has pledged never to charge transaction fees at any time in the future. And the management fees of its ETFs are comparable to the lowest in the industry i.e. ones provided by Vanguard Group.

3.) Though Schwab is late to the game in manufacturing ETFs, it hits the ground running as a custodian of these assets. Not only are 11% of ETF assets in the US held through Schwab but it holds 22% of the ETF assets held by retail investors.

4.) Schwab’s ETF move may just be a warm-up act for a much bigger play in the market, Tom Lydon, editor of ETF Trends says. The company pioneered the no-transaction-fee mutual fund supermarket, OneSource, and it’s conceivable that it could pull off a similar innovation with ETFs. OneSource is one of Schwab’s major profit centers; it charges as much as .4% on the mutual fund assets purchased through its platform. Lydon sees a scenario where even companies like Barclay would be willing to pay a small fee to be on such a Schwab ETF platform. “Barclays is a huge player but they don’t have a custodial platform,” Lydon says. Schwab does not rule out the possibility of creating a supermarket of ETFs. “We don’t have any specific plans at this time but we’re always looking for new ways to innovate for clients, says Lindsay Tiles, spokeswoman for the company.

Tom Lydon: “Barclays is a huge player but they don’t have a custodial platform.”
Tom Lydon: “Barclays is a huge
player but they don’t have a
custodial platform.”

5.) Schwab’s foray into ETFs will benefit from the total buy-in of its chairman and founder, Charles “Chuck” Schwab. “Chuck himself loves ETFs and he owns them himself,” Lydon says. “I asked Peter Crawford [senior vice president, investment management services group for Schwab]: How does Chuck feel about this,” he says. “I saw him light up.” Lindsay Tiles, a spokeswoman for Schwab, confirmed what Lydon says. “Chuck is very happy about this launch, yes,” she says. “Both he and Walt [Bettnger, CEO of Schwab] like that our offer is great for advisors and active investors, but also that the no-commission trading provides a way for smaller investors to dollar cost average into the market.”

6.) In Schwab’s Advisor Outlook study completed earlier in the year, 43% of RIAs say they plan to increase ETF ownership. Though 80% of Schwab RIAs own ETFs but the assets only make up on average 10% of advisors’ clients’ portfolios. “It’s a huge number of relationships still stuck in conventional mutual fund land,” Lydon says.

7.) There’s no good explanation for why so many advisors are still in mutual funds unless they are philosophically sold on active management, Lydon says. Another possible factor is trading commissions. “It may be that I don’t want my client to see a $12 commission on my statement and I don’t want to explain that on top of my 1% fee,” he says. “That hits you right between the eyes. It may be a small amount but it’s an annoyance factor – even for large clients.” Schwab’s elimination of fees could have an outsized effect with advisors for this reason — like a bank that eliminates ATM fees.

8.) Another reason that the fee elimination could make a difference is that many RIA practices have “plumbing” that is designed primarily to handle mutual funds. For example, many advisor may not be comfortable with the trading aspect of ETFs like having to place limit orders and the like, Lydon says. The elimination of trading fees on ETFs may nudge some RIAs to make these long-postponed changes in plumbing.

9.) Advisors still have a lot of cash on the sidelines in the wake of the economic downturn. The ETF program may be Schwab’s way to encourage advisors to bring some of that cash back into the market. Lydon says.

10.) It’s possible that Schwab could offset lost ETF commission revenue by using the underlying stocks for securities lending, Lydon says. Tiles says she has not heard anything about this. [Editor’s Note: I’ll try to write more about this if I can find out.]

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