The cost of investing in exchange-traded funds has been racing downward in recent years on both sides of the Atlantic. Just this past Tuesday, the latest volley of the ongoing price wars was fired by Fidelity’s US retail brokerage. A landmark deal with iShares will allow investors on Fidelity’s brokerage platform to buy and sell 25 ETFs covering nearly every major category of fixed-income and regional equities without a trading commission (for more details on the Fidelity and iShares agreement, please see this article). This move marks a brand new area of progress for ETF investors. The fund companies themselves have slashed fees in the past, reducing total expense ratios to fractions of those seen in traditional funds, but the trading commissions to buy or sell an ETF had remained an inescapable and unchanging cost of investing in this new fund type. That all changed just three months ago.
The new agreement between Fidelity and iShares was spurred by a rival retail brokerage in the US, Charles Schwab. Schwab unveiled plans for eight ETFs in November 2009 that would not only have among the lowest expense ratios of any funds in the US market, but would also trade for no commission on the Schwab brokerage platform. Schwab hoped to make money on its low fund fees by building up assets, and began to provide free ETF trades as a way to entice Schwab clients into their new funds and immediately offer liquidity for other potential investors. The company succeeded, as their eight new ETFs had assets of $550 million (£350 million) by the beginning of February. However, success drew competition. After this response from Fidelity, we would be surprised if other US retail brokerages do not start to offer their own ETFs or partner up with an existing provider to give their clients some commission-free ETF options.
What does this mean for the UK?
Clearly exchange-traded funds have become the new battlefield in US
brokerages’ fight for customers. And as with any other price war, we
expect the customers will be the greatest victors of all. But what are
the chances that this success will carry over to the UK or continental
Europe anytime soon? Unfortunately, in the next couple of years,
probably very slim. However, as the retail investor base develops
further in the UK and comes to embrace index trackers such as ETFs, we
would be surprised if similar price-slashing competition does not break
out here.
American brokerages are jumping over themselves to offer free trades in ETFs because massive assets are at stake. Roughly 50% of ETF assets in the United States come from retail investors: a whopping $400 billion (£250 billion). In Europe, not only is the ETF market much smaller, but only around 10% comes from retail investors, for a total of around £15 billion. This is not yet enough to attract aggressive pricing cuts from brokerages, but we expect that to change before too long. As defined benefit pension plans continue to decline and individuals start saving more on their own for retirement, we expect retail investor assets to swell. Regulatory changes such as those pushed by the Financial Services Authority’s Retail Distribution Review will push advisers away from commissions-based compensation and towards a fee-based model in the next couple years, which should encourage the growth of low-cost, low-or-no-commission investments like ETFs. The US market provides an excellent precedent for investors in this case, and the expanding retail assets in ETFs will make them prime targets for brokerages attracting business through price cuts.
The price wars in Europe
Of course, the price wars are not solely an American phenomenon. Even if
commission-free ETF trades might be a few years off, investors can take
heart that European ETF providers are still cutting total expense ratios
more aggressively than their US counterparts. In fact, the swap-based or
synthetic replication structure in the European market gives providers
remarkable flexibility to generate income from a securities portfolio,
and has allowed them to go where no US company has dared with their
costs: all
the way to zero.
This latest bit of news from the US market just serves as a reminder of how intense the competition is over exchange-traded funds and their tremendous asset potential. Providers trip over themselves to offer the best total expense ratio and transparency, market makers strive to keep bid-ask spreads narrow and trading costs low, and even brokerages are slashing their commissions. As usual, when financial firms have to compete, it’s investors who win.
