This Broker's Losing the Free-ETF Battle

After a brief lull in the ETF price war that discount brokers have waged since the last part of 2009, investors have started seeing action again from brokers fighting to win customers. But the latest arrival to the battle, Interactive Brokers (Nasdaq: IBKR  ) , has taken a new tack -- and it's not one that most investors should give much attention.

Going for the tag-team
Until Interactive Brokers arrived on the scene, the broker ETF wars all involved mainstream ETFs. Charles Schwab (NYSE: SCHW  ) opened with a substantial commission cut overall and offered its new line of low-cost ETFs at no-commission. Fidelity's answer involved 25 of BlackRock's (NYSE: BLK  ) iShares ETFs, which it supplemented last month with five more funds. Vanguard upped the ante by offering its entire suite of in-house ETFs at no commission, and TD AMERITRADE (Nasdaq: AMTD  ) one-upped them all with a vast offering of more than 100 ETFs from across the universe of fund managers.

But for its commission-free ETFs, Interactive Brokers turned to a newcomer in the ETF space, FactorShares. Its five ETFs just started operating last month, and as you'll see below, they're engineered not for mainstream investors but for high-octane traders who are interested in maximizing leverage.

Why spread ETFs are dangerous
The FactorShares ETFs that Interactive Brokers is offering at no commission are a new breed of funds called spread ETFs. Each spread ETF makes a leveraged bet on the difference in return on two different market segments. For instance, the FactorShares 2x S&P 500 Bull/T-Bond Bear (NYSE: FSE  ) attempts to double the daily return of an index that has a leveraged long position in E-mini S&P 500 futures contracts and a leveraged short position in Treasury bond futures.

That may sound reasonable, especially if you expect stocks to go up and bond prices to fall as interest rates rise with a strengthening recovery. But there are risks involved, and just as Reuters analyst Felix Salmon did, all you have to do to find them is look at the FactorShares FAQ. Here are some tidbits:

  • They're not for long-term investors. As the FAQ puts it, "[E]ach Fund will not track its corresponding Index for a period longer than a single trading day and may experience tracking error intra-day."
  • The leverage is massive but variable. "Each Fund targets a leverage ratio of approximately 4:1 upon daily rebalancing since each dollar invested provides approximately two dollars of long exposure to one benchmark futures contract and two dollars of short exposure to another benchmark futures contract. Prior to rebalancing, however, the leverage ratio could be higher or lower than an approximately 4:1 leverage ratio."
  • They're a pain for tax purposes. "Each Fund will be classified as a partnership for U.S. federal income tax purposes. ... Each Schedule K-1 provided to a Shareholder will set forth the Shareholder's share of the Fund's tax items in a manner sufficient for a U.S. Shareholder to complete its tax return with respect to its investment in Shares of each Fund."

A management fee of 0.75%, which is high compared to competing funds, is also an argument against the ETFs. Combined with other costs, expense ratios could run as high as 1.1% to 1.2%, according to FactorShares' CEO.

Tailored to the client
It's true that Interactive Brokers tends to cater to a more aggressively trading clientele than some of its more staid brokerage competitors. In that light, offering leveraged ETFs is at least consistent with the company's overall strategy.

But the best argument against the Interactive Brokers decision to offer commission-free ETFs is that IB prides itself on its rock-bottom commission schedule. Buying 200 shares of any ETF costs only $1 at IB. So it's not as if any but the biggest buyers of ETFs is really saving much by using FactorShares ETFs.

This battle's over
Even if Interactive Brokers had to make a move in the ETF price wars, this wasn't the right one. With State Street (NYSE: STT  ) still lacking an exclusive partner for its SPDR ETFs, grabbing hold of one of the largest players in the ETF industry would have been the right move. I still expect E*TRADE Financial (Nasdaq: ETFC  ) to grab that bull by the horns to its advantage. IB missed a chance here, and in the long run, its commission-free offering will have to expand beyond FactorShares to make an appreciable impression in the broker wars.

Click on Interactive Brokers, State Street, or E*TRADE to add them to your watchlist, or start a new watchlist and add any company you want. You'll get valuable updates as well as immediate access to a new special report, "6 Stocks to Watch from David and Tom Gardner." Click here to get started.

Fool contributor Dan Caplinger hates to see companies make the wrong move. He doesn't own shares of the companies mentioned in this article. Interactive Brokers Group and Charles Schwab are Motley Fool Stock Advisor picks. BlackRock is a Motley Fool Inside Value recommendation. The Fool owns shares of Interactive Brokers Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy makes all the right moves.

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