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Last year set a record for annual ETF inflows at $476.1 billion, and last month $68.1 billion were added to ETFs, the largest total for any month ever in the product’s history. Investors of all types—institutional, advisory, and individual—have adopted ETFs as a key tool for portfolio-building. Registered Investment Advisors (RIAs) have embraced ETFs as a solution for their clients and rely on broker/dealer platforms to service their accounts. As a result, RIAs possess great influence on ETF distribution since they select the ETFs and the platform to use in building client portfolios. RIAs look for ETFs that provide the exposure they need, at low cost. ETF issuers looking to capture market share have responded by emphasizing distribution, increasing investor access to their products by offering them commission free. That’s a sure-fire attention-grabber.

Most ETF issuers focus on developing products that will attract investor interest. In turn, they rely on broker/dealers to distribute their products. This business model allows ETF issuers to focus on building ETFs and broker/dealers to focus on working with investors. In this situation, ETF issuers do not compete with broker/dealers. The ETF issuers receive compensation via the ETF expense ratios, while broker/dealers receive compensation from investors typically via a fee for their advice.

Offering ETFs Directly or Via Partnerships

A handful of ETF issuers also have their own broker/dealer platform, meaning they develop products and allow investors to come directly to them to buy/sell ETFs. This business model allows the ETF issuer to receive compensation via its ETF expense ratio and collect a fee for providing advice. This also gives them the flexibility to waive the fee for advice, or commission, if the investor feels comfortable making their own investment decisions.

The ideal position for ETF issuers is to have their products available on as many platforms as possible in order to easily reach investors.

When Vanguard entered the ETF business as a way of distributing its product, it began offering them free of commissions through its broker/dealer. Schwab, Fidelity, and most recently USAA, offer their products free of commissions as well to account holders. Distribution is relatively easier for these firms since they all serve as both the ETF issuer and a broker/dealer. For clients of these firms, it's great; lower costs are always a good thing.

For other ETF issuers, we quickly saw partnerships develop. ETF issuers would partner with broker/dealers to provide compensation in exchange for waiving commission charges on transactions in their ETFs. As anyone involved with these partnerships will tell you, though, they can be tricky. It is imperative to have a solid agreement in place.

Compensation for these partnerships may be in different forms, such as payments for increased educational resources, access to portfolio or risk tools, marketing dollars, flat dollar fees, or a fee in the form of percentage of invested assets per year (or share in basis points). Typically, the basis points charged range from 0 to 0.15% depending on the ETF or ETF issuer.

Through these partnerships, broker/dealers wished to offer products and support for their advisors and clients. Initially, ETF issuers wanted to partner with brokerage platforms that shared similar approaches. The strategy was to provide specific products to address specific solutions. Broker/dealers that focused on long-term investing would partner with an ETF issuer to provide products designed more for investing purposes, making it easier and more efficient for long-term investors.

Broker/dealers that were focused on daily average revenue trades perhaps would partner with ETF issuers that were more open in their approach to gathering assets in their products. The strategy was to simply offer as many ETFs free of commissions as possible; the higher the number, the better. There seemed to be little regard for how the ETFs would fit in an investment portfolio. It has quickly become confusing for individual investors who must now consider over 300 commission-free ETFs.

RIAs Now Defining ETF Partnerships

We have recently seen these partnerships change. In October of last year, TD Ameritrade completely overhauled its platform. Earlier this month we saw modifications again from TD Ameritrade and E*TRADE. The recent modifications signal another shift, one less focused on partnership and more on leveling distribution. No longer do we see exclusive partnerships of one broker/dealer and one ETF issuer. The ETFs that appear on the various commission-free platforms appear to be driven by the needs of RIAs. We see the number of ETFs available on the platforms continue to grow which provides an RIA with more flexibility. In addition, the type of ETFs that are now being included are also the type of funds an RIA would use to build portfolios.

Below is an overview of the various platforms:

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Making ETFs available free of commission opens up the distribution channels and gathers more assets into the products. Having more assets in the products continues to lower the costs of managing the funds. There is a tipping point, though. Simply having “the most” available products for free makes it more confusing. It is possible to deliver a diversified portfolio using six ETFs. The “less is more” approach also makes the investment process less complex for investors to understand and follow.

Having a large number of products available to trade anytime should make us consider what’s best for investors.  Often times the average holding period for the ETFs on these lists decrease, suggesting that investors are less committed to a position when transaction costs are waived. In many cases the average number of positions used for a diversified portfolio is also increasing, often times unintentionally.

In summary, as ETFs become more widely used, and we as an industry position the product, it is important to keep in mind that in this case “free” only increases the need for quality research and sound advice.

Author's Note: Commission free means you can buy and sell the exchange-traded funds (ETFs) at the respective broker/dealer without paying brokerage commissions. Most firms place limitations or restrictions on purchasing ETFs on margin. To discourage short-term trading, firms often charge a short-term trading fee based on a specified number of days. The lists of commission-free ETFs are subject to change at any time without notice.

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Senior Analyst, ETF Analytics
Lois joined FactSet in 2017 and is based in Chicago.

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