A few weeks have gone by since we have written a post warning investors that the ETF industry is not your friend.  Thankfully today we have some additional fodder to add to this line of reasoning.

Charles Schwab & Co. (SCHW) recently launched a handful of broad-based equity ETFs with rock-bottom expense ratios.  Good. In addition they also announced that Schwab customers can now trade these ETFs commission-free.  Great.

On the face of it there is nothing to object to here.  However Schwab isn’t doing this out of the goodness of their collective hearts.  They have two goals.  The first is to attract assets to their ETFs.  Second they want to attract enough trading interest in the funds to bring down the funds’ bid-ask spreads.  If this tactic works for Schwab you can bet that other firms with a client list of sufficient size to try this as well.

There the risk that Schwab stops this program at some point in the future.  There is also the risk that the ETF industry gets further splintered into walled fiefdoms where one can trade only house-branded funds commission-free.  (See Ron Rowland at Invest With an Edge for other possible industry outcomes.)  While this may not be a horrible thing, but it should give one pause.

Izabella Kaminska at FT Alphaville reports that one ETF issuer in Europe, db x-trackers, have gone so far as to waive fees on their ETFs.  She notes other ways, like securities lending and index arbitrage, that firms can profit off of ETFs even if they are not earning explicit fees.  In conclusion Kaminska writes:

To surmise, commission-free ETFs may very well lower fees for the industry as a whole, and that is a good thing, but there’s no real benefit to investors unless the business they attract tightens bid-ask spreads too.

Going from low fees to high fees in the past week or so OOK Advisors LLC launched two new state-focused ETFs, the Oklahoma ETF (OOK) and the TXF Large Companies ETF (TXF).  Two points on these funds.  The first complaint about these funds is that they are “gimmicky.”  As Vincent Fernando at The Money Game writes:

While the concept of capturing the Texas economy is good, the ETF itself appears to be little concerned with actual Texas exposure and more so with making high fees and appealing to many people’s affinity with the state.

Don Dion at TheStreet notes that the index construction is flawed in that it focused on firms headquartered in the state as opposed to firms deriving revenues primarily from within the state.  On the other hand Roger Nusbaum also at TheStreet has a more favorable view of the Oklahoma ETF and thinks it might be a viable small to mid-cap energy play.

A second more vexing issue than the composition of the two funds is the issue of fees.  As Michael Johnston at ETF Database writes:

The old saying that everything is bigger in Texas apparently applies to expense ratios as well. TXF charges 85 basis points, more than ten times the fees charged by the cheapest ETF options for exposure to large cap equities (two of Schwab’s new ETFs offer expense ratios of 8 basis points).

High fees are bad enough.  As Johnston notes over time the difference in fees compounded can have a material affect on returns.  But the funds’ sponsor is implicitly justifying these fees by noting:

A minimum of ten percent of OOK management fees will go to Aaron’s Bridge to facilitate access to more treatment options in Oklahoma and Texas for children with developmental disabilities, including Autism Spectrum Disorder.

Charitable giving is a worthwhile endeavor and this sounds like a worthy cause .  However it does not follow that the way to do this is on the back of the firm’s ETF shareholders.  As Fernando notes:

That’s the worst, when you snag clients with higher than necessary fees by making yourself look charitable.

As you can well see there are a number of moving parts with these funds.  At the very least investors need to go in with their eyes open in regards to these funds’ portfolio construction and fees.

Just because some gimmicky funds catch fire with investors and advisers does not mean they were good ideas to start.  The sad fact is that many gimmicky funds end up as zombie ETFs on the ETF Deathwatch.

Update: Matt Hougan at IndexUniverse commenting on the Schwab moves, “An over time, I expect the Schwab funds will gain significant assets. It just won’t happen overnight.”

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