Editor's note: An earlier version of this story erroneously reported that Charles Schwab earned $231 million from commission-free ETFs and mutual funds in the quarter ended June 30, 2017. Schwab earned $238 million in fees from such funds during the period. The Fool regrets the error.
TD Ameritrade's (AMTD) change to its list of commission-free exchange-traded funds (ETFs) shows how the brokerage industry, increasingly threatened by passive investing, faces a difficult choice balancing investors' wants with its need to generate a profit.
Trading commissions, once the industry's bread and butter, are trending down as the industry slashes prices and investors eschew stock picking for passive index funds and ETFs. That means brokers have to get creative with how they generate revenue, and commission-free ETFs are increasingly playing a role as a revenue driver for many of the industry's largest companies.
Swapping commissions for royalty-like fees
It wasn't all that long ago that brokers preferred stock traders to fund investors. That's because brokers historically earned a small, up-front commission on each trade, and stock investors trade far more often than fund investors. That has changed, however, as brokers pair up with fund companies to offer free trades on certain funds in exchange for their share of the management fees.
Many know Charles Schwab (SCHW -0.66%) as a master of the business model. In the most recent quarter, Charles Schwab earned an average annual fee of 0.33% of assets on products in its Mutual Fund OneSource list, funds investors can invest in without paying a commission. It also booked an average fee of 0.09% on client assets invested in "third-party mutual funds and ETFs," funds on which it does not charge commissions to investors to buy or sell.
Charles Schwab can afford to give its clients no-commission trades on these funds because it stands to make a healthy profit from sharing in ongoing fees. Last quarter, the company generated $238 million of fee income primarily by incentivizing its clients to invest in other companies' funds and ETFs. In contrast, Schwab earned just $151 million in trading revenue, primarily from commissions charged on client trades.
This is the upside of a shift toward funds rather than active stock picking. After all, commissions are an irregular, transactional source of revenue, whereas the fees earned from mutual fund and ETF managers are a royalty-like revenue source that should only grow over time. As I wrote before the most recent salvo in the commission price war, commissions made up less than half of net revenue for the largest discount brokers. Recurring fund fees and interest earned on loans and client account balances are often the largest slice of the pie and are far more predictable than commissions, which ebb and flow with market volatility.
Why TD Ameritrade's change is a big deal
TD Ameritrade was one of the last holdouts on monetizing commission-free ETFs. As it explained in its annual reports, it offered its clients "over 100 commission-free ETFs," all of which were "selected by independent experts at Morningstar Associates, LLC."
Morningstar had the power to choose funds for the list based on its own parameters. Naturally, it picked some of the lowest-cost ETFs designed for long-term buy-and-hold investors. Familiar funds included S&P 500 trackers such as the iShares Core S&P 500 (IVV -0.02%) and high-performing "Smart" ETFs like the top-tier Vanguard Dividend Appreciation ETF (VIG -0.37%).
You won't find these funds on TD Ameritrade's updated list of commission-free ETFs. Investors who previously used the iShares S&P 500 ETF for broad market exposure will now find a collection of "smart beta" S&P 500 ETFs that pick stocks from the S&P 500 based on their historic volatility or whether they fit "growth" or "value" parameters, instead of funds that simply track the index as a whole.
Vanguard's popular low-fee index funds, once a staple of TD Ameritrade's commission-free list, will entirely disappear from the commission-free lineup. To be sure, its funds aren't available in commission-free form at Charles Schwab, or any other discount broker, for that matter. Vanguard has a long-established policy that it does not pay for distribution, believing that it makes more sense to simply have the lowest fees and compete on price alone.
This isn't to speak ill of discount brokers. After all, they provide a valuable service at prices that have only gone down over time. In 2001, discount brokers charged an average commission of $21.67 per trade. Today, many charge less than $5 for the same service, and all are priced under $10 per trade.
That said, take this as a reminder that there are few free lunches in investing, and brokers can't and shouldn't be expected to do it all for free. Money has to come from somewhere, and it appears that commission-free ETFs will become more than just a reason to open an account, but a way for brokers to generate a profit, too.