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Schwab Tackles the ETF Business

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After months of behind-the-scenes planning, Charles Schwab finally has its own menu of proprietary ETFs. In November 2009, the San Francisco -based company began launching its first series of ETFs and as of mid-January had eight funds.

Unbeknownst to many, Schwab has quietly been one of the largest ETF distributors through its retail and RIA brokerage platform. And now it’s an ETF manager.

Through its $210 billion asset management unit, Schwab is rolling out a complete ETF lineup. Thus far, major asset classes like international, emerging markets and U.S. stocks have been covered. Fixed income and perhaps commodities are probably next.

Adding to Schwab’s foray into the ETF business is a series of strategic moves that could shift asset flows away from today’s dominant players. According to the company, Schwab’s 7.7 million brokerage clients can now make commission-free trades on all Schwab ETFs. Furthermore, Schwab eliminated the 12b-1 marketing fees on its ETFs in order to keep annual expenses rock bottom. Will these aggressive moves backfire on the company or will they work? And what will it mean for the rest of the ETF industry? How can advisors prepare their clients for what lies ahead?

Research interviewed Jonathan de St. Paer, vice president, product development at Charles Schwab, to talk about this and more.

How much assets under management (AUM) in non-Schwab ETF assets does Schwab have? And how does that compare to a few years ago?

Schwab clients have grown their ETF assets rapidly over the past several years. As of November 2009, Schwab had $84 billion in ETF assets, which is 31 percent above the $64 billion that we had as of December 31, 2007. This represents much higher growth than the 1 percent growth in mutual fund assets over the same period.

Schwab serves a large base of independent advisors. What percentage use ETFs in portfolio management today?

Our research indicates that 83 percent of registered investment advisors (RIAs) on the Schwab Platform actively use ETFs today, and an additional 3 percent don’t use them today but plan to in the future.

Some observers would view Schwab’s move into the ETF business as belated. How do you respond to that?

First, I’d like to clarify that our launch of Schwab ETFs is not our first move into the ETF business. For years, Schwab has been a leading platform for ETF investing; providing both retail investors and RIAs with broad access to ETFs as well as industry-leading ETF tools and research. In managing ETFs, we’re building off that strong foundation.

Second, we believe it’s only the second or third inning in the development of the ETF industry. Retail investors and RIAs have only recently begun to adopt ETFs in a meaningful way, and we anticipate that this adoption rate will accelerate going forward. Our newly launched Schwab ETFs provide a compelling solution to investors’ ETF needs today, and will also solve for the needs of investors who are only now learning about ETFs and beginning to invest in them.

Many of Schwab’s ETFs like SCHB and SCHX follow indexes already tracked by other ETF providers. Where’s the advantage for investors?

We’re providing clients with quality products, at a truly breakthrough price when you consider the industry-leading expense ratios and zero commission trading.

A chief complaint made against ETFs is they aren’t suitable for dollar-cost averaging (DCA). But waiving trading commissions on Schwab ETFs for Schwab clients makes it more feasible. Could this be a much needed push to get ETFs inside 401(k) and other retirement plans that encourage the practice of DCA?

Certainly one of the major benefits of our approach to online trade commissions on Schwab ETFs is that it does enable investors to dollar-cost average into the market. This is a major improvement over the traditional model, in which all trades incur commissions. While this improvement addresses one major hurdle to widespread adoption of ETFs in 401(k) programs, substantial hurdles still remain.

In addition to the structural issues around 401(k) accounting and reporting systems generally not supporting ETFs, there are further issues that should be considered. For example, some of the key benefits of ETFs, such as their tax efficiency and the ability to trade them intraday, are not meaningful in infrequently traded, tax-deferred 401(k) accounts. In addition, while passive ETFs are generally lower priced than active mutual funds, they will face stiff competition from passive mutual funds and collective trusts, which can be lower priced than many ETFs. The mutual funds and collective trusts also allow investors to invest at the net asset value of the fund without also paying a bid/ask spread. ETFs will play a material role in 401(k)s in the future, but the path to success may be challenging.

Schwab offers mutual funds that follow fundamentally weighted indexes constructed by FTSE RAFI. Are there any plans to offer Schwab ETFs based upon these same strategies?

We do not currently have plans to offer fundamentally weighted index ETFs.

Do you view ETFs as complementary products to mutual funds and vice versa or are they competitively destructive enemies?

We very much see ETFs as complementary to mutual funds. The two vehicles have distinct benefits that appeal to different investors. We will continue to work to ensure we have the solutions our clients need, whether they prefer to invest through the mutual fund vehicle or through ETFs.

What’s more important to the ETF industry’s asset growth: Is it actively managed funds or ETFs becoming a serious player in the retirement plans landscape?

To be honest, I’m a bit skeptical about active ETFs. In certain asset classes, they may make sense. There is a lot of hype about them, but I don’t see a lot of investors clamoring for ETF versions of actively managed large-cap growth funds especially if the expense ratios will be substantially higher than on existing passive products. At the same time, ETFs face some challenges in penetrating the retirement world. Of the key benefits of ETFs — tax efficiency, intraday liquidity, low costs and transparency — all will apply to active ETFs. In contrast, as mentioned above, 401(k) accounts only benefit from a limited set of the benefits of the ETF structure.