Exclusive: Schwab eyes commission-free ETF supermarket - sources

Charles Schwab Corp has been quietly meeting with exchange-traded fund providers to try to persuade them to join a new network that would make ETFs available commission-free to the brokerage's 8.6 million customers.

ETF providers, however, have been reluctant to sign on to Schwab's plan because they would have to pay the firm a marketing fee they say is too high, according to people with knowledge of the discussions.

While it is common in the mutual fund world for asset managers to pay a fee (known as 12b-1) to brokerages that sell and promote their funds, it is rare in the ETF market. Most brokerages market ETFs for free and make their money by charging investors a trading commission.

Schwab's plan, if successful, could blaze a trail through the ETF industry, which experts say has few other options to grow while keeping costs low. And if Schwab's pioneering effort in mutual funds is any indicator, competitors such as Fidelity and TD Ameritrade Holding Corp would likely follow suit.

"This is the next area for price competition," said Noah Hamman, chief executive of AdvisorShares, a Bethesda, Maryland-based exchange-traded fund provider.

An ETF network could be a financial boon for Schwab since fees paid by ETF providers generate a source of steady revenue. Commissions, on the other hand, are paid by investors or financial advisers for trades, which are less predictable. Trading volumes this year are at multi-year lows. In November alone, trading volume at Schwab fell 27 percent year-over-year.

For ETF providers, joining Schwab's platform could help raise assets in an increasingly crowded market. But despite more than a year of wooing, the sticking point is the marketing fees that would make it harder to keep the cost of investing low ��� a hallmark of index-based ETF portfolios.

The ETF industry is in the midst of a fee price war and some popular ETFs now charge investors as little as a few pennies per $100.

Schwab is proposing that ETF providers pay the brokerage distribution and marketing fees in the range of 0.05 and 0.10 percent, said two officials, who declined to be identified as the talks were private. Schwab has proposed a choice of an annual flat fee or an asset-based fee within that range, said one of the officials. The range, though, is too high for many providers to make a profit, they said.

"This is ultimately being subsidized by the ETF providers, who have to put the cost somewhere else," said Ben Johnson, director of ETF research at Morningstar. "This could just be the situation where we learn that there is no free lunch."

A Schwab spokeswoman declined to comment on whether the brokerage is pursuing an ETF platform.

"As the largest custodian of retail ETF assets and a top provider of proprietary ETFs, we have many conversations across the industry and are constantly exploring new opportunities," she said.

INDUSTRY PIONEER

As the $1.29 trillion ETF market has become more crowded - more than 1,234 funds are now available in the U.S. compared with 658 five years ago - some have agreed to pay marketing fees in exchange for commission-free status on brokerage platforms.

BlackRock Inc's iShares has had such a deal with Fidelity Investments' brokerage for three years. E*Trade Financial Corp last year started offering commission-free ETFs by WisdomTree Investments Inc , Global X and Deutsche Bank AG . The companies would not disclose the marketing fees.

But Schwab would be the first to create a commission-free ETF supermarket with funds from multiple firms, so figuring out how much ETF providers should pay is a challenge.

Some ETF providers are also uncomfortable that Schwab has its own ETFs - some of which are cheaper - and would not be subject to the fees, officials said.

Despite these concerns, three ETF officials told Reuters that, if one of the big three ETF providers, BlackRock, State Street Corp's State Street Global Advisors or The Vanguard Group, participated in the platform, they might follow suit.

"Schwab probably has the best connection to the self-advised account," said one of the ETF officials familiar with the discussions. "But we are not going to jump into this alone."

Spokeswomen for State Street, BlackRock and Vanguard, the latter of which does not pay marketing fees to any firm, declined to comment.

Schwab's proposed ETF network is modeled after its highly successful platform for mutual funds called OneSource.

When OneSource was launched two decades ago, asset managers also balked at the 0.25 percent marketing fee Schwab proposed and only 80 mutual funds signed on. The number increased as the platform proved essential to gaining visibility with investors and financial advisers.

As of September 30, OneSource had more than $215 billion in assets and 4,197 funds. Schwab says it gets 0.31 percent for every client dollar that goes to the funds.

"That is a good number given the scale they have," said Rich Repetto, an analyst at Sandler O'Neill. "Schwab has so much going through OneSource and it's not extremely volatile, while trading can go up and down."

The average expense ratio for an equity mutual fund is 1.24 percent, compared with 0.356 percent for an equity ETF, according to Lipper Inc, a subsidiary of Thomson Reuters Corp . That means an investor pays $1.24 for every $100 invested in a mutual fund and less than 36 cents for every $100 invested in an ETF - a 71 percent gap.

(Reporting By Jessica Toonkel; Editing by Lauren Young, Jennifer Merritt,; Tiffany Wu and Andre Grenon)