Schwab Enters the Era of Zero-Cost Trades: Do Active Managers Have Another Thing to Worry About?

By Gary Sarkissian posted 10-01-2019 13:58

Image by Steve Buissinne Pixabay
Image by Steve Buissinne from Pixaba

In 2017, when TD Ameritrade was nearing the completion of its acquisition of rival Scottrade, I came across a very enticing yet not-so-widely advertised promotion through Charles Schwab for existing Scottrade clients that seemed too good to pass up.  What was the offer?  If I agreed to transfer over my Scottrade accounts, Schwab would give me commission-free trading for as long as I was a Scottrade client.  And since I had started investing with Scottrade in 2004, that offer meant I could trade for free with Schwab until the year 2030!

What seemed like a sweetheart deal at the time has now transitioned to the norm, as Schwab has announced its decision to eliminate commissions on U.S.-listed equities for all of its clients. While underscoring the ongoing and fierce price war among low cost investment and indexing providers such as Vanguard and Fidelity, Schwab’s decision also highlights the evolving business model for online brokers, with the focus shifting to an advice-oriented model and away from a transaction-driven one (although Schwab, in particular, also relies considerably on its interest rate-sensitive banking business). 

Of course, to anyone who has invested with an online broker over the past three decades, the question of whether trading commissions would hit zero was not a matter of if, but when. The pricing squeeze isn't only visible to the end investor, either: the cash equities trading businesses for exchange companies such as Nasdaq (NDAQ) and NYSE-parent Intercontinental Exchange (ICE) have become heavily commoditized, resulting in these firms shifting their attention over the years to more profitable and less volatile revenue streams such technology outsourcing and proprietary data services.

Now that we are comfortably settling into the era of commission-free trading for individuals, what are the implications for active managers?  From one side, managers face competitive pressure from low-cost passive products, which in some cases are offered at an expense ratio of 0%.  Now, it seems that these managers are facing an even higher return hurdle given the closing cost gap with individual investors, and—in a more severe scenario—are being disintermediated even further from those investors’ assets. In the past, financial advisors touted to their clients the cost-effective nature of mutual funds, as transaction costs greatly hindered a do-it-yourself investor from replicating the scale advantage that a professional manager would have. Today, that advantage has been rendered meaningless.

Regardless of the one’s perspective on the relevance of active managers going forward, one thing is becoming clearer off the heels of Schwab’s salvo to the rest of the industry: access to capital markets, directly or indirectly, is becoming even cheaper to mainstream investors. While that outcome may not necessarily eliminate an active manager’s ability to produce alpha, it does place added pressure on the value proposition of investing with that manager.

There is one bright side, though: however this landscape shakes out for industry players, what is reassuring is that individual investors end up the ultimate beneficiaries.