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Who Will Win This Race to the Bottom?

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There's nothing better for customers than a price war. For a while, competing companies beat each other up, offering increasingly attractive deals to woo new clients to their services. As long as those competitive pressures don't drive the companies out of business, customers get a smorgasbord of great deals.

That's exactly what's happening in the online brokerage industry right now. After three major brokerages have come out with offers allowing their customers to trade certain ETFs on a commission-free basis, now Charles Schwab (NYSE: SCHW  ) has fired another salvo hitting another hot-button issue: fund expenses.

Nickeled and dimed to death
In the mutual fund and ETF world, fees are the most pernicious thing you have to fight against. Every year, win or lose, up or down, a portion of your money gets funneled over to the managers who run the funds you own. The less you lose to fees, of course, the more you get to keep for yourself.

The focus of Schwab's latest announcement is that it has cut the operating-expense ratios on six of its proprietary ETFs. Here's a quick breakdown:

  • Schwab US Broad Market (NYSE: SCHB  ) : 0.08% to 0.06%
  • Schwab US Large Cap Growth: 0.15% to 0.13%
  • Schwab US Large Cap Value: 0.15% to 0.13%
  • Schwab US Small Cap: 0.15% to 0.13%
  • Schwab International Equity: 0.15% to 0.13%
  • Schwab Emerging Markets: 0.35% to 0.25%

Although most of the reductions were only a few hundredths of a percentage point, they were enough to make Schwab's offerings cheaper than what Schwab sees as its primary competitors: Vanguard, BlackRock's (NYSE: BLK  ) iShares, and State Street's (NYSE: STT  ) SPDRs. In particular, the move fired a warning shot over competitor Vanguard's bow: Don't count on being the low-cost leader without a fight.

A nice trend to see
ETFs originally distinguished themselves with the promise of low expenses compared to ordinary mutual funds. Since most ETFs track indexes, it makes sense that they should cost less than actively managed mutual funds that can change strategies at will.

But actually, that hasn't stopped many providers from going the other way with their ETFs. ProShares, for instance, recently came out with leveraged ETFs on a variety of international indexes, including the MSCI Brazil index. Yet its expense ratio weighs in at a hefty 0.95% -- close to what you'd pay for a typical actively managed mutual fund.

Similarly, despite hefty competition in emerging-markets ETFs, iShares Emerging Markets (NYSE: EEM  ) has steadfastly kept its expense ratio at a hefty 0.72%, even though the similar Vanguard Emerging Markets Stock ETF (NYSE: VWO  ) weighs in at just 0.27%.

So in that light, Schwab's move is nice to see. Here's what impact I think it's likely to have on the other players involved:

  • Vanguard. I don't think Vanguard will get too upset about getting undercut by the smallest of margins. The company has a reputation for being a cost leader, and the much bigger size of its funds makes its cost-cutting moves more sustainable as the funds are economically viable.
  • iShares. iShares has lagged on cost-cutting for a while, but the fund company would argue that what it charges for expenses is more than made up by the reduced trading costs from their more liquid ETF offerings. Having not responded to some fairly large price disparities between iShares and Vanguard ETFs, iShares likely won't take any action.
  • State Street. Increasingly, State Street finds itself marginalized in the ETF industry. It needs to find a partner and come up with some innovative ways to differentiate itself from its faster-moving competitors.

While all these companies sort out their differences, though, you're in the best position to reap the benefits as ETF providers race toward the bottom on cost. By focusing on low-cost funds that serve useful purposes in your portfolio, you'll make sure everything will go your way.

If you want to buy ETFs, you need the best broker you can find. Check out the Fool's Broker Center to get the scoop today.

Fool contributor Dan Caplinger is waiting for a World Cup ETF. He doesn't own shares of the companies mentioned in this article. Charles Schwab is a Motley Fool Stock Advisor pick. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is racing higher all the time.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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Related Tickers

10/23/2014 9:31 AM
BLK $321.63 Up +5.75 +1.82%
BlackRock CAPS Rating: ****
EEM $40.84 Up +0.10 +0.25%
iShares MSCI Emerg… CAPS Rating: ***
SCHW $26.49 Up +0.48 +1.85%
Charles Schwab CAPS Rating: ***
STT $68.80 Up +0.90 +1.33%
State Street Corp CAPS Rating: ****
VWO $41.14 Up +0.10 +0.25%
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