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“This is an unexpected move by Vanguard, and absolutely the next salvo in the ETF fee war.” – Dave Nadig, Managing Director of ETF.com

 

A ruthless ETF fee war escalated this week with Vanguard announcing 1,800+ ETFs (pretty much every ETF except leveraged and inverse) will be available commission-free through their online brokerage platform.  Because ETFs trade intraday like stocks, investors typically pay a small ticket charge ($5 – $10) to buy and sell shares – no different than when trading shares of Apple or Facebook.  While representing a tiny fraction of overall portfolio costs (especially for well-disciplined investors who resist the urge to overtrade), commissions are still a cost of investing.  Anytime fees can be reduced, investors win.  But there’s more to Vanguard’s move than meets the eye.

Over the past several years, a growing number of brokerages including Charles Schwab, Fidelity, and TD Ameritrade have rolled out commission-free ETF platforms.  For example, Charles Schwab offers 200+ commission-free ETFs from providers such a State Street, Invesco, and WisdomTree, as well as their own low cost ETFs.  Of course, nothing good is ever really free.  Behind the scenes, most ETF providers pay to have their ETFs included on these platforms (note paying for distribution isn’t unique to ETFs; it’s been going on for years in the mutual fund space).  Brokerages are for-profit companies and need to get paid for services rendered.  If investors aren’t paying trading commissions, the money has to come from somewhere.

For ETF providers, it makes perfect sense to pay for these platforms.  Think about your local grocery store.  There’s a reason Doritos or Fruity Pebbles have prime shelf space.  You’re more likely to buy them – and you do!  Food companies pay millions of dollars for coveted placement in stores knowing that increased sales will more than make up for the costs.  For newer, less recognized brands, shelf space is even more important when trying to break in and gain market share.  Exposure is everything.  Same thing in the fund world.  Commission-free platforms are a great way to get noticed by fee sensitive investors and advisors.  Look no further than the SPDR Portfolio ETFs, a suite of 15 low cost, core exposure ETFs launched in October and immediately added to TD Ameritrade’s commission-free platform.  Below are net flows into these ETFs since the addition (figures are in millions of dollars):

Source:  ETF.com

 

The bottom line is the shelf space model can work.  Now, speaking of TD Ameritrade’s commission-free platform, when the SPDR Portfolio ETFs were added last October, 32 Vanguard ETFs were dropped.  The removal of Vanguard’s ETFs from TD’s platform caused such an uproar among advisors that TD was effectively forced to delay the move for two months.  More importantly, this appears to have played a significant factor in provoking Vanguard’s move this week.  At the time TD booted Vanguard, John Woerth, a spokesman for Vanguard told RIABiz:

“We share in the disappointment of many advisors in TD Ameritrade’s decision, as Vanguard ETFs represent some of the lowest cost, most broadly diversified products available in the marketplace. And Vanguard’s brand is a name that advisors’ clients know and trust.”

And therein lies the rub.  You see, unlike many other fund companies, Vanguard refuses to pay for inclusion on commission-free platforms or any other form of distribution.  As Vanguard spokeswoman Emily Farrell succinctly conveyed to AdvisorHub:

“Vanguard does not pay for distribution—we do not pay platforms or advisors to sell our mutual funds or ETFs.”

Why?  Well, number one – they don’t have to.  They’re Vanguard.  While other ETF providers may struggle to bring in assets and gain visibility around their brands, Vanguard takes in $1 billion/day(!) across their ETFs and mutual funds.

Source:  Eric Balchunas, May 3rd

 

Number two, Vanguard is relentless about driving down the costs of investing – which obviously goes hand-in-hand with why they rake in a billion dollars a day.

Because Vanguard is so unrelenting on reducing investor costs, TD ran into a tiny little problem including Vanguard ETFs on their commission-free platform.  Investors and advisors flocked to these ETFs, meaning TD didn’t make any money.  Remember, Vanguard doesn’t pay for inclusion on these platforms and the ETFs traded commission-free.  Worse, Vanguard sucked money away from other ETFs on TD’s platform, where assets are typically the key driver in the pay-to-play formula.  TD attempted to solve this dilemma by booting Vanguard off the platform and replacing them with a fund company who would pay.  Vanguard’s response?  Go nuclear.  Offer nearly every ETF commission-free on their brokerage platform.

Before delving any further, I need to give proper credit to Michael Kitces, who provided a fascinating, in-depth analysis on the potential impact of Vanguard’s decision.  Michael believes this is the biggest industry news of the year and its significance has been largely overlooked by the media.  His analysis unquestionably helped frame my thoughts around this topic and I can’t more highly recommend watching the below video if you want a deeper dive:

So, what is the potential impact here?  First, let’s not overstate the commissions savings aspect of Vanguard’s move.  We’re talking about $5 – $10 per trade in savings to investors.  Not nothing, but certainly not making or breaking a portfolio.  I always shudder at the thought of investors simply selecting ETFs at various platforms because they’re on a commission-free list, only to pay higher fund fees or larger bid-ask spreads or more importantly, for subpar exposure to a particular asset class.  Most ETF investors at Vanguard were likely already using at least some Vanguard ETFs, which have always traded commission-free.  Also, Vanguard investors aren’t typically the type that like to day trade and churn their accounts.  They tend to be longer-term, buy-and-hold investors.  Plus, keep in mind that while 1,800+ ETFs are available commission-free, investors simply don’t use most of them.  As a matter of fact, the top 20% of ETFs by assets comprise 94% of the total ETF market:

Source:  Morningstar’s Jeffrey Ptak

 

The real significance of Vanguard’s move is their attempt to disintermediate the pay-to-play, commission-free model altogether.  The fees fund companies pay to have their ETFs appear on commission-free platforms are ultimately shouldered by shareholders through higher fund costs.  Vanguard’s move puts further fee pressure on ETF providers who are paying for distribution.  If other providers don’t lower fees (presumably partially by eliminating distribution costs), they will have a difficult time competing with the Vanguard ETFs on Vanguard’s brokerage platform.  If they don’t pay for distribution on other platforms, they may have a more difficult time competing generally (it would be fascinating to see what would happen if both the SPDR Portfolio ETFs and Vanguard ETFs were offered commission-free at TD in terms of investor flows).  Either way, Vanguard – and investors – win.  Karin Risi, Managing Director of Vanguard’s Retail Investor Group:

“Vanguard has led the industry in reducing the cost and complexity of investing for all investors for more than four decades. We’ve driven down the costs of funds. We’ve driven down the cost of advice. Now, we’re driving down the cost of investing in ETFs.”

While costs are always front and center for Vanguard, this move is also about transparency.  Vanguard is shining a bright light on the pay-to-play model, which inherently has conflicts of interest.  Investor dollars should flow to funds based on merit, not because they appear on commission-free lists.  Smaller ETF companies without the budget to pay for distribution should have the same opportunity as larger companies.  To be clear, there’s nothing nefarious about commission-free platforms at brokers like Schwab and Fidelity.  They should absolutely be compensated for services they provide.  There’s also nothing wrong with fund companies attempting to market their ETFs.  The problem is that the current model is broken.  Vanguard is attempting to blow it up.