Earlier this week, Vanguard announced that in August it will begin offering commission-free ETF trading through its Investor.Vanguard.com online brokerage platform on a whopping 1,800 ETFs... which includes not just its own ETFs, which were available commission-free already, but virtually all ETFs, including those from all their major competitors like Blackrock, State Street, and Schwab (on top of the 2,500+ mutual funds already available through Vanguard without trading fees). Yet while the media immediately jumped on the announcement as a new stage of the price wars on ETF trading costs, as Vanguard's platform will offer nearly 5X - 10X the breadth of ETFs as their largest competitors... the real significance of Vanguard's announcement is much bigger.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss why the real impact of Vanguard's announcement is a potentially fatal disruption to the nature of no-transaction-fee (NTF) ETF platforms themselves, undermining existing pay-to-play distribution agreements to the most popular NTF ETF platforms today, and potentially pushing RIA custodial platforms instead to charge advisors (or investors) a more transparent and less conflicted basis point fee directly for the clearing, custodial, and other services they provide.
Some historical perspective on the use of shelf-space and revenue-sharing distribution agreements for fund providers may be helpful to understand why Vanguard's announcement is so disruptive. The first “no transaction fee” (NTF) online brokerage platforms got going in the 1990s, pioneered by companies like Schwab with their OneSource program, establishing a giant online supermarket of mutual funds that were made available (and funded) by 12b-1 shareholder servicing fees and sub-TA fees instead of charging "traditional" transaction fees to purchase a fund. But then along came ETFs, which "felt" like mutual funds to many consumers who wanted to be able to buy them without transaction fees as well... except, ETFs don't have a 12b-1 fee or a sub-TA fees! As a result, when the online brokerage platforms wanted to offer ETFs under a no-transaction-fee platform, they needed a new way to get paid. What emerged was brokerage platforms negotiating “distribution” agreements directly with the ETF providers that effectively said, "If you want to be listed in our NTF platform, you need to pay us directly", taking the form of other a revenue-sharing agreement (paying basis points for assets on the platform) or "shelf-space" agreements (which are typically negotiated flat fees and not set as basis point directly, though they are still effectively loose basis point equivalents based on total assets). The key point: one way or another, fund providers had to pay to be on the NTF platform, which is why most NTF ETF platforms have a limited lineup (or only those providers willing to pay).
And, mostly out of necessity for distribution opportunities, many fund providers have paid to be on these platforms. The bold exception to this trend was fund companies like Vanguard and DFA, which were notorious for not paying dollars under the table to get onto these NTF platforms. Early on when many NTF ETF platforms were being built out, Vanguard still wasn’t nearly as dominant in the ETF space as they are today, so many companies allowed Vanguard onto their platforms as a way to validate their platform (with Vanguard's name recognition) in the hopes of attracting clients who might also use some of the other NTF funds (that do pay to be listed). But as Vanguard has continued its meteoric rise over the past several years, Vanguard attracted so much in assets onto these platforms that it was adversely impacting the profitability of the entire platforms... leading companies to swap Vanguard out for other ETF providers that were more willing to pay to participate.
And that is why it’s such a big deal that Vanguard made the announcement this week that it’s going to make virtually all ETFs available on its own online brokerage platform. The significance is that they’re offering a no-transaction-fee platform without requiring the same back-end shelf space payments that all the other brokerage and custodial platforms require. In other words, the latest move by Vanguard isn’t a price war against ETF trading fees; instead, it's declaring war on the entire model of asset managers being forced to pay back-end revenue-sharing and shelf-space agreements to get onto those platforms in the first place, by offering their own and not charging the asset managers what everyone else charges!
How will this potentially play out from here? ETFs that currently pay NTF platform fees are compelled to increase their expense ratios to cover the cost (because the money has to come from somewhere to pay)... except now ETF providers have a problem: their ETF expense ratios are boosted higher to compete on NTF platforms at companies like Schwab, Fidelity, and TD Ameritrade, but the higher expense ratios to cover the distribution costs on those platforms will reduce their competitiveness on the new mega Vanguard platform! As a result, ETF providers may be compelled to start creating a new series of their popular ETFs, with those additional distribution costs stripped out, creating a lower-cost "clean ETF" that can better compete in a true NTF environment. Yet once this happens, since the ETFs will be available elsewhere as well (just with a transaction cost instead) it will recreate the multiple-share-class effect we have now in mutual funds, where there’s a higher cost version of the mutual fund in the NTF platform – because it’s pushed up by the 12b-1 and sub-TA fees – and then there’s a lower cost version of the same mutual fund you can buy directly. Which ultimately will lead to consumers (and advisors) adopting whichever fund is cheaper in their situation, putting further pressure on custodians to offer less conflicted models where investors (or advisors) are simply charged a transparent basis point fee for the clearing and custodial services provided instead.
But ultimately, the key point is to acknowledge that the real news is not that Vanguard is simply offering a larger NTF platform than other providers. The real news is that this may be a fatal disruption to NTF platforms themselves, and a step towards a more transparent model of custodial services over the more conflicted models of back-end distribution agreements that currently exist!