Schwab’s ETF Gift Horse

Schwab announced a huge expansion to its commission-free program. What’s not to love?

On Friday, Charles Schwab announced it was expanding its ETF OneSource program to bolster the ranks of ETFs for which you pay no commission for more than 180 funds. This is of course good news for investors.

After all, costs are the most pernicious—and predictable—part of investing, so anytime someone’s saving investors money, I’m happy. But it’s important for investors to understand what their options are, and what the missing pieces might be.

First, a few words about the program. Schwab’s program is extremely simple. If you have a regular old Schwab account, and you happen to trade one of the 182 ETFs on its list, then you don’t pay any commissions. You don’t have to sign up for anything. The only thing you’ll pay is an exchange processing fee on sales, which comes out to 22/100ths of a basis point (roughly $1.00 on every $50,000 of sales).

Parsing The List

In general, the ETF list is well-rounded, and most investors will be able to cobble together a well-diversified portfolio with the funds on offer. The issue is really just the lack of name brands on the list. For fairly obvious reasons, the most attractive “Core” ETFs on the expansive list are all from Schwab. And to be clear, it’s a solid list of funds:

These are in fact some of the cheapest ETFs in the market. In a few cases (like the analyst pick Schwab U.S. TIPS ETF (SCHP | A-99), they’re amazingly good ETFs. SCHP beats its nearest competitor on expense ratio by 11 basis points. The Schwab U.S. Large Cap ETF (SCHX | A-95) and the Schwab U.S. Total Market ETF (SCHB | A-100) have the honor of being the two cheapest equity funds in the market.

Which begs the question, honestly: Why do investors need the other 161 ETFs in the OneSource program? The answer is simple: all the weird stuff. Notably missing from the above list are commodities, active funds, currencies, alternatives, dividend strategies, sector funds, min vol and so on. And what Schwab has done, rather prudently, is only allow those funds into the list that have relatively high expense ratios, and that don’t directly compete with their core offerings.

Put it this way: The average expense ratio (weighted by where the money actually is) in the Schwab funds on the big list is 7.6 basis points. The asset-weighted average of the non-Schwab funds? 48 bps.

There’s a reason the number for the non-Schwab funds has to be so high. Each of the issuers participating in the program is paying something to Schwab for the privilege. That’s how the regular-old mutual fund OneSource program has always worked.

However, since there are no fat 12(b)1 fees baked into ETFs, some sort of firm-level deal for product placement is most likely in place. And if you’re the issuer wading into Schwab, you’re not going to put your cheap products in, and then take a loss on every dollar.

When you combine the two razors that determine which funds get in and which funds don’t, you end up with some slightly odd lists. For example, in the latest barrage of PR, it was notable to see Pimco on the list. But if you look at the list of Pimco funds included, you may notice some absences.

There’s nothing wrong with these funds per se, but where are the really good ones, the ones people probably actually want from Pimco, like the Pimco Total Return ETF (BOND | B) or even the Pimco Enhanced Short Maturity Strategy (MINT | B)? The answer, I suspect, is that those two actively managed strategies would be seen as competing too directly with Schwab’s core bond ETFs. Ditto the very popular suite of Pimco TIPS ETFs.

Similarly, while SSgA is the biggest issuer in the group (no iShares or Vanguard ETFs here), and has some 48 ETFs represented, the collection of ETFs is not what you might expect. You won’t find the SPDR S&P 500 (SPY | A-98) or the SPDR Gold Trust (GLD | A-100) or any of the Select Sector ETFs on the list, despite their enormous popularity.

In fact, the largest ETF you’ll find from SSgA on the Schwab list is the SPDR Barclays Convertible Securities ETF (CWB | C), a fund that barely cracks the top 20 ETFs offered by SSgA by assets. And you’ll find products all the way down to the tiny, almost $3 million SPDR MFS Systematic Value Equity ETF (SYV | D-69).

Why? Because SYV has an expense ratio of 60 bps and has absolutely no chance of stealing assets from Schwab’s entry in the segment, the plain-vanilla Schwab U.S. Large-Cap Value ETF (SCHV | A-90).

Gift Horse Dental Exam

So is the Schwab program all that and a bag of chips? It depends. I’ve personally been a Schwab customer since I first started investing, two months before the market crash of 1987 (and yes, boy do I have impeccable timing).

When Schwab waded into the ETF market, I did what most prudent and boring investors did: I waited to make sure the assets and volumes were there, and as I made new allocations to long-term positions, particularly in taxable accounts, I considered the Schwab funds. I do in fact have a position in SCHB.

Schwab’s OneSource expansion can best be described as extremely shrewd. They can legitimately market that you can get everything from long-dated oil contracts to Swedish krona to hedge fund replication without a commission.

Certainly, there’s a class of investor out there who’s going to be actively trading these narrower slices of the market, and perhaps the ability to do so cheaply draws those assets into Schwab.

If I were in Schwab’s shoes, I’d be pretty certain that a big chunk of that money actually just ends up parked, like mine, in the cheap, boring stuff. And that’s how Schwab wins. It’ll get 80 percent of those clients’ new assets. And the 20 percent that gets actively traded in the narrower stuff? Well, it’ll make plenty of money on that as well, I’m sure.

At the time this article was written, the author held a position in SCHB. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.