The firm is slashing fees on index funds and lowering investment minimums as it faces competition from exchange-traded funds
Is this a sign of things to come for mutual fund investors? Charles Schwab Investment Management, a division of Charles Schwab Corp. (SCHW), said on May 5 that it was cutting fees on its six equity index funds to market-leading levels, and lowering its minimum investment requirement to just $100 in order to give all investors access to the lower fee structure.
The cuts are intended to better serve existing customers rather than a reaction to any specific competitive pressures within the industry, Schwab said. But it's clear that Schwab, like all mutual fund providers, is feeling the heat from the growing popularity of exchange-traded funds (ETFs) over the past few years. ETFs' growing acceptance is not surprising: They not only typically charge lower fees than conventional mutual funds, but provide more flexibility and transparency to investors. They also give holders the ability to better control the taxes they pay on any capital gains they realize.
As of May 5, investors with at least $100 invested in the Schwab S&P 500 Index Fund and the Schwab Total Stock Market Index Fund will pay an annual fee of just 0.09% of their portfolio's value, down 53% to 83% from prior expense ratios for various share classes. The fees were cut to 0.19% in International Index Fund and the Small-Cap Index Fund and to 0.29% in the 1000 Index Fund. As an added incentive to investors, Schwab consolidated all of the share classes within the equity index funds to just one share class, which gives all investors access to the lower fee structure previously enjoyed only by institutional investors. The fee in the Institutional Select S&P 500 Fund was trimmed slightly from 0.10% to 0.9%.
Following Fidelity's Lead
Schwab's move places it alongside other ultra-low-fee competitors. In March 2005, Fidelity Investments said it had rewritten the contracts of five U.S. equity index funds to contractually bind the funds to total expenses of 0.10% each, which prevent the fees from being raised without a vote of the funds' shareholders. That fee cap applies only to clients who have at least $10,000 invested with Fidelity, but clients can qualify for it with an initial investment of just $500 if they invest through the Fidelity Automatic Account Builder, under which they commit to contribute at least an additional $100 each quarter. Fidelity says it regularly evaluates its pricing but has no plans to further reduce fees at this time.
Investors in the Vanguard 500 Index Fund Investor Shares still pay an annual fee of 0.15% of their portfolio as long as they have at least $3,000 invested.
The reduced fees could result in increased market share for Schwab, given that roughly half of its new clients are friends and family members referred by existing clients. "Our referral business is most important to growing our franchise," says Randall Merk, executive vice-president of Schwab's Investment Management Services.
Schwab Has Fat Margins
Another reason is that having reduced its expenses to 0.27% of the total assets it manages for clients, Schwab's margins are wide enough that they can withstand the lower fees, says Merk. "We're leveraging our low overhead," he says, "We're in a position where we can have a little [lower] pricing because in the end it will result in more flow to Schwab from new clients and existing ones."
Schwab currently manages about $15 billion in assets in its index funds, and $10 billion in its actively managed funds, which are dwarfed by $202 billion invested in its money market funds. If the assets in its index funds were anything near those in its money market funds, Schwab very likely wouldn't be cutting fees, says Matt Snowling, an analyst at Friedman Billings Ramsey & Co. (FBR) in Arlington, Va. (FBR or its affiliates act as a market maker in Schwab's securities.)
Expense ratios across the mutual fund industry were coming down for a few years before reaching a plateau last year but now are poised to rise again, at least for actively managed funds whose assets have been shrinking, says Russ Kinnel, director of mutual fund research at Morningstar (MORN).
Investor Awareness Growing
Actively managed funds typically have break points for fees based on the size of assets under management, which means that as assets fall below those thresholds, fees have to rise, he says. The rally in equities over the past two months "should reduce the impact a bit, but we're only just barely into the black, which means funds are still going to [have] something like 20% to 40% smaller assets than they [did] a couple years ago," he says.
Most investors only slowly become aware of higher fees, since they are usually reported at the end of the fiscal year, typically in October. There probably won't be much reaction where fees go up by just a few basis points, but where the hikes are more substantial and the funds have also lost a lot, there will probably be more of a backlash by investors, says Kinnel.
By the end of 2009, Schwab plans to launch its first series of proprietary ETFs that will be made available not only to clients who invest through financial advisers but to its self-directed clients as well, says Merk. It's an effort to be more relevant to investors who balk at paying fees on an index mutual fund when ETFs are so cheap, says Jeff Mortimer, Schwab's chief investment officer.
Targeting ETF Investors
With about $60 billion of clients' money already invested in other companies' ETFs, which translates to roughly 10% of all ETFs volume, "we believe Schwab is already a major player in ETFs," says Merk. "We would like to be a bigger player in ETFs."
More than 20% of Schwab's trading volume may now be coming from individual investors trading in ETFs, which is double what it was a year ago, says Snowling. One big draw of ETFs is the ease with which investors can move into and out of equity market sectors, which is more important amid heightened market volatility.
Schwab, along with other providers of money market funds, has had to slash or even waive their fees in those funds temporarily in order to keep those yields positive. The high demand for low-risk assets until recently has severely depressed yields on the short-term Treasury bills in which money market funds invest.
Sacrificing to Keep Customers
With so many billions of dollars currently invested in its money market funds. Schwab "can't afford to wake up one day with a negative yield on those," says Snowling at FBR. "Cash would just walk out the door. That's the price they're willing to pay to maintain that customer base."
On a recent conference call with investors, Schwab said it may give up as much as $200 million in fees this year as a result of supporting positive yields in its money market funds, says Mark Lane, an analyst at William Blair & Co. in Chicago. It gave up less than $10 million in fees in the first quarter of 2009, he adds.
Low Treasury yields prompted Schwab to close its U.S. Treasury Money Fund to new accounts on Dec. 2, 2008, in order to reduce the assets the fund needs to invest at historically low yields.