Who’ll Pay For Vanguard’s Free ETF Trades?

May 04, 2010

Hooray! Vanguard launches free trading! But wait, maybe we should really be in mourning.

It came as little surprise that Vanguard launched free trading in its ETFs for Vanguard brokerage customers this morning. (Matt Hougan covered the breaking news this morning). Their move follows the example first set by Schwab, with the launch of their ETFs last year, and the subsequent deal between Fidelity’s brokerage business and BlackRock’s iShares products.

Unfortunately, this deal is even worse for investors than the previous examples.

Such sentiments aren’t popular. Lord knows I received enough hate mail when I decried the move by iShares to go commission-free at Fidelity. But let’s follow the logic here.

Trading costs something to someone. Regardless of what brokerage you’re working with, if you place an order to buy 1,000 shares of the Vanguard Emerging Markets ETF (NYSEArca: VWO) at $40, that order has to, by law, go through the vast intertwined network of systems that make up the NBBO (National Best Bid and Offer). So Vanguard’s brokerage, which we can assume operates as a nice little independent business line, can’t just magically hand over shares of VWO for free. A trade still happens.

How much that trade should cost is obviously the subject of much debate and speculation, but let’s just pretend that the “real” cost of executing that 1,000-share trade is $5, once someone buys Bill McNabb new running shoes and polishes the statue of John Bogle down there in
Valley Forge. It’s probably a reasonable estimate, as Vanguard charges between $2 and $7 for trades on securities that aren’t part of the new commission-free ETF program.

That’s $5 to buy the ETF and $5 to sell it. So you’re paying $10 in trading costs, or 2.5 basis points, on your $40,000 investment that have to be absorbed somewhere. Now, let’s be clear: My imaginary expense could be much, much less than this (the longer you hold, the lower the amortized cost, and there are efficiencies in the process to be sure), or it could be more expensive (if I’m day-trading VWO, I might incur that $10 round trip 100 times a year). But let’s just assume that the cost is real, and non-negative.

Someone Pays

So in this commission-free world, who pays?

In the case of Schwab, the answer is easy—Schwab’s corporate shareholders pay. Schwab, as a for-profit, publicly traded company, is in the business of delivering profits to its shareholders through asset management, transaction costs and effective cash management. So when they decided not to charge their customers for trading their ETFs, they’re making the bet that the lost revenue on the trades will be offset either by higher cash balances (where brokers make a ton of their profit) or more assets under management in the ETFs themselves.

If Schwab’s right, owners of Schwab’s stock win. If they’re wrong, they lose. Theoretically, if Schwab is really wrong, expenses or commissions somewhere in the Schwab Borg Cube have to go up, or shareholders will be unhappy.


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