A race to the bottom

Filed in Asset Management

Can introducing a blistering pace of ETFs and allowing clients to trade them at no cost be anything other than a zero-sum game? This could be the case for one integrated asset management firm.

Introduction:

Since entering the ETF market in late 2009, there is no doubt that the pace of new ETFs and inflows to ETFs has been quite impressive at Charles Schwab Investment Management:

13 ETFs launched since 2009
2 new ETFs launched the week of January 9, 2011
Assets under management (‘AUM’) in Schwab’s ETFs exceeded $2 billion (as of November 2, 2010),
Schwab Managed Portfolios™ Exchange-Traded Funds (‘SMP-ETFs’), which debuted in January 2010 through Charles Schwab Investment Advisory Inc., has garnered $1.7 billion (as of October 29, 2010)

Is this a Zero-sum Game?

Many of Schwab’s ETF have been introduced at expense ratios equal to or even lower than the industry recognized low cost ETF provider, Vanguard. The two funds launched this past week are designed to compete against Vanguard:

U.S. REITs ETF (“SCHH”) has the same annual expense ratio of 0.13% as the investor share class of the Vanguard REIT Index ETF (“VNQ”)

U.S. Domestic mid-cap stock ETF (“SCHM”) was introduced at an expense ratio of 0.13%, which is cheaper than its rival Vanguard Mid-Cap ETF (“VO”), that has an expense ratio of 0.14%

Factoring in that Schwab clients can trade the ETF shares with no commissions online through a Schwab account likely reduces the profitability of these ETFs for Schwab.

In fact, two of Schwab’s overall financial ratios would tend to support the case that Schwab is likely making very little on their ETF offerings. Let’s look at Schwab’s trailing twelve month Return on Assets (‘ROA’) and the Net Profit Margin:

Return on Assets over the Trailing Twelve Months = 0.64%

At a ratio of less than 1%, Schwab’s ability to operate profitably is well below their 3 year average of 2.10%

Utilizing ROA to measure the management effectiveness helps identify how well a company’s management uses its assets to generate profits. This ratio is particularly relevant for banks which typically have huge assets.

Net Profit Margin over the Trailing Twelve Months = 12.15%

Schwab’s Net Profit Margin has dropped to a level not seen in the last 3 years. When measured against their 3 year average, Schwab has seen their Net Profit Margin fall by 44% (21.69% to 12.15%)

To me, it is hard to see how competing on expense ratios against Vanguard makes sense. While the ETFs have helped Schwab Investment Management capture an impressive $2 billion, this ETF race is one that Schwab is unlikely to win.