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The Shot Heard 'Round The World? Schwab Launches No-Commission ETFs© Sound Mind Investing | December 2009
The financial press is abuzz over an early November announcement from Charles Schwab. The discount broker and mutual-fund company unveiled eight new Schwab-branded exchange-traded funds (ETFs) that investors can buy and sell without paying a commission. Schwab's ETFs also have tiny expense ratios, as low as .08 percent in some cases (i.e., 8 cents on a $100 investment). Walter Bettinger, president and CEO of Charles Schwab, boasted "We think this is game-changing within the ETF space." Some analysts agreed. "This could be the shot heard around the world," said Morningstar's Scott Burns, invoking a phrase associated with both the start of the American Revolution and the 1914 assassination that sparked World War I. Burns' analogy might be a bit over the top, but Schwab's move — the first of its kind by a major discount broker — seems certain to put downward price pressure on other companies' ETF commissions. Some might even adopt a similar commission-free model, opening the ETF door to millions of average investors who, until now, have seen ETF investing as too expensive. But couldn't this move by Schwab simply be a teaser rate to attract new customers who will face a fee hike later? "This is not a promotion," insisted Scwhab's Peter Crawford in an interview with Morningstar. "This is not a teaser. It's not a gimmick. There are no catches, no caps. This is our ongoing commitment." Keep in mind that Charles Schwab is the company that pioneered the idea of the no-transaction-fee "fund supermarket." That model was a great success, and apparently Schwab is convinced the no-commission-ETF model will be successful as well. WHAT IS AN ETF ANYWAY?Most exchange-traded funds are similar to traditional "index" funds. The majority of ETFs are passively managed funds designed to track certain market indexes. (Most of the new Schwab funds, for example, track various Dow Jones indexes.) But important differences separate ETFs from traditional mutual funds. For one thing, ETFs can be bought and sold at any time throughout the day — unlike mutual funds, which price only once per day after the markets close. Theoretically, you could invest in an ETF at 10 a.m., sell it at noon, and buy it back at 3 p.m. (Not recommended.) In essence, then, ETFs are mutual funds that trade like stocks. Because they trade like stocks, certain features are available to ETF investors that aren't available when investing in mutual funds, such as stop-loss orders for downside protection. Other differences: ETFs generally have no minimum-investment requirements, no redemption fees, and — because ETFs rarely have capital gains distributions — they tend to be more "tax efficient" than mutual funds. To top it all off, ETFs typically have lower expenses than mutual funds because they don't require as much customer-service support. These positives have attracted a huge amount of money to ETFs over the past decade. However, one key sticking point that has kept some investors from making the switch has been the cost of commissions. For each ETF trade (purchase or sale), the investor had to pay the amount of a regular stock trade. Even at the lower-cost brokers, that could mean $10-$20 for each trade. For the average investor socking away $200-a-month toward retirement, a $10 commission is basically the same as paying a 5% load. That made the cost of ETFs too steep for many individual investors, given the alternative of purchasing traditional index funds for free. WHERE DO THEY FIT?If you're a regular Sound Mind Investing reader, you know we emphasize long-term accumulation, not short-term speculation. So, from our perspective, the fact that ETFs can be traded at any time during the day is of relatively little value (indeed, that particular "feature" may be more temptation than benefit). But we do like the low expenses of these ETFs, as well as the lack of both redemption fees and minimum-investment requirements. In short, the elimination of commissions makes these ETFs worth considering. But "worth considering" and "recommended" aren't the same thing. First of all, it's important to reiterate that Schwab is only making eight ETFs available without commissions — all other ETFs will continue to incur them. Second, it will take some time to determine how these new ETFs compare to other index-fund options. For example, a Schwab account holder might consider replicating a Just-the-Basics approach with these Schwab ETFs, using the U.S. Large Cap, U.S. Small Cap, and International Equity ETFs. And that may be a perfectly good plan. But it's worth noting that Schwab's small-cap ETF is 78% invested in what Morningstar labels "small-" or "micro-" sized stocks. By contrast, the Vanguard Extended Market fund recommended in JtB is only 49% invested in small/micro stocks, with the majority of the rest invested in mid-caps. We're not saying either approach is right or wrong, but that's obviously a significant difference, meaning the potential exists for these seemingly similar investing approaches to wind up with performance that varies quite a bit from each other. As a result, we're inclined to take a wait-and-see approach to these Schwab ETFs for now. We love the idea, and if other brokers follow suit, this could indeed be the beginning of a significant shift in the index-investing landscape. Schwab account holders can certainly dabble a little here if they are so inclined, but for most readers, we'd advise letting these ETFs establish a track record first, to confirm that their investment performance turns out as expected (and see how it compares to the slightly differently configured JtB funds at Vanguard). At that point, these new ETFs may prove to be a great alternative. If nothing else, this puts the pressure on other brokers to answer Schwab's move with similarly investor-friendly steps of their own. And that's always a good thing.
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