Schwab Vs. Vanguard: Battle Royale?

August 20, 2009

Schwab isn't just moving into ETFs. It's also focusing more on index mutual funds, possibly posing Vanguard's biggest threat in years.


Does Vanguard finally have a real competitor in the index mutual funds market?

In May, Schwab slashed prices on five of its index funds. The maverick discount broker and asset manager is clearly aiming at luring away some of Vanguard’s $557 billion in index fund assets. (That includes some $67 billion in exchange-traded funds, a market Schwab’s also preparing a big push into later this year.)

San Francisco-based Schwab has sounded the first salvo in what it hopes to be a long-term fight for the hearts and minds of indexers by:

  • Cutting expense ratios on the Schwab S&P 500 Index Fund (SWPPX) and the Schwab Total Stock Market Index Fund (SWTSX) from 0.35% to 0.09% each. Both now are half the annual costs of the Vanguard 500 Index Fund (VFINX) and the Vanguard Total Stock Market Index Fund (VTSMX), which each assess 0.18% in annual expense ratios for investor share classes.
  • Reducing annual fees on the Schwab Small-Cap Index Fund (SWSSX) from 0.52% to 0.19%. That actually undercuts the Vanguard Small-Cap Index Fund (NAESX), which charges 0.28%.
  • Knocking expenses on the Schwab International Index Fund (SWISX) to 0.19%, less than its closest Vanguard rival. That’s the Developed Markets Index Fund (VDMIX), now at 0.29% in annual fees.

But can long-term-oriented investors trust such price reductions to remain permanent?

If you remember, Fidelity Investments in 2005 tried to do much the same, undercutting Vanguard by reducing ERs on several rival index funds to 0.10%. Those changes were only enacted as temporary waivers, however. When investors and reporters (including myself) tried to find out what assurances the Boston-based mutual fund giant might offer that such ERs would stick, Fidelity fudged.

Later, it made the 0.10% permanent on most of those funds. Among members of the Diehards discussion board on Morningstar and the ensuing Bogleheads forum—the most astute online communities for index mutual fund investing—people were openly critical of Fidelity’s foot-dragging on the issue.

It’s fair to say that the fund shop known for its actively managed funds lost a lot of the good will they had expected to gain in the indexing crowd by low-balling Vanguard’s prices.

At the same time, Vanguard didn’t hesitate to meet the challenge. They wouldn’t budge on fees since as a shareholder-owned company, ERs were already set by how much it cost to run the funds—not necessarily by how much profits they could make.

Vanguard officials argued that reacting to Fidelity’s move would only harm its investors by artificially selling funds for less than it cost to administer the portfolios. The fact that the Valley Forge, Pa.-based indexing pioneer had been kicking the industry in the pants for decades with its significantly lower cost structures gave such a response all the credence it needed. As a result, it’s doubtful a whole lot of people switched to Fidelity just over price.

Some investors did take advantage of the situation, however. I certainly did since my retirement plan includes Fidelity’s index funds. So it’s a nice little perk to be able to invest through my workplace in the same asset classes and save a nice chunk in fees each year.

Winning Investors’ Trust

It's not surprising to expect Schwab to face the same sort of skepticism now as Fidelity did when it openly challenged Vanguard’s indexing empire.

“We were watching when Fidelity changed its cost structure with its index funds. We’ve certainly learned from that experience,” said Michael Bonardi, Schwab’s director of investment management services. “We wanted clarity from the outset that our cost reductions were designed as permanent, not temporary, changes.”

Schwab has also made their funds open to anyone with $100 or more to start. Vanguard index funds generally have a $3,000 minimum. Although that isn’t a deal breaker for many, certainly Schwab stands to attract a lot of younger investors with such low minimums.

What will they find in terms of selection? Fidelity right now offers no pure small-cap stock index fund, although it does have an extended market version (FSEMX) and an enhanced small-cap fund (FCPEX). But the latter has an expense ratio of 0.68%. Also, like its non-enhanced indexing cousins, FCPEX requires at least $10,000 to invest in through a non-IRA account.

Other gaps in Fidelity’s straight market-cap size indexing line include no emerging markets or style-based funds. It does have separate large-cap growth and large-cap value enhanced funds—at 0.45% expense ratios, which seem reasonable compared with similar competitors.



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