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

May 04, 2010

In the Fidelity/iShares deal, it’s more complicated. There, iShares is writing a check to Fidelity to cover the costs of commissions, in exchange for having a commission-free presence on Fidelity’s brokerage site. The bet here is that iShares as an entity gets more assets, which means the profit lost by writing the check is offset. If iShares is right, then BlackRock gets a bigger check. If they’re wrong, just like at Schwab, the enterprise will demand profits from somewhere, theoretically putting upward pressure on expense ratios.

In both cases, I argue that this reintegration of trading costs into the ETF makes what was a beautiful, transparent division of costs as clear as mud. No longer is each investor carrying his or her own trading weight. Now, all investors, in a sense, are carrying the weight of the community’s collective trading proclivities. That one guy who trades 100 times a year is doing so on the back of the guy who just puts in one buy order a year and never moves his money.

Now consider Vanguard. Vanguard, unlike these other organizations, lives with a different kind of mandate. It delivers its products effectively at cost. Vanguard investors love this for the most part, but it’s not always a one-way street. In 2009, Vanguard raised expenses on dozens of products, including ETFs, because the real costs of those funds were simply higher than they’d been previously.

So guess who’s going to pay for all this “free” trading? Vanguard investors. Because investors in Vanguard’s products are also the actual investors in Vanguard’s company. Vanguard is literally owned by its fund shareholders. So that means every shareholder of VWO just became a kind of health insurance company, covering the bad behavior of Vanguard brokerage customers on the back of their buy-and-hold investments.

It’s easy to see “free” in the headline and think it’s great, but Robert Heinlein said it best: TANSTAAFL – There Ain’t No Such Thing As A Free Lunch. Especially in the Vanguard cafeteria.

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