Voices Does Schwab's growth threaten Vanguard's domination? By Allan S. Roth January 22, 2020, 10:44 a.m. EST Imagine it’s 2030 and Schwab now dominates the retail investing industry. It’s more than twice the size of its nearest competitor, Vanguard. Old-fashioned index mutual funds and ETFs stagnate with essentially no net asset inflows. While this picture is far from a certainty, it could happen. Here’s why it could and what it means to you and your clients. Vanguard has been sucking up assets but today, the $6 trillion company has a real threat — Charles Schwab. Schwab is poised to upend the industry with no fees, higher quality service and better products that could make traditional index funds and ETFs obsolete. Schwab has made three big announcements recently. The connection between the three may not be obvious, but together, they indicate what could be a brilliant strategy. It eliminated commissions on stocks and ETF trades. It agreed to buy TD Ameritrade in a $26 billion deal. It said it would offer fractional shares in stocks. How do these add up to what I call a possible brilliant strategy? Understand that Schwab, the original discount broker, is no longer in the brokerage business. In fact, it appears the asset management business is merely a side business and a money loser at that: They are charging less than their costs. About 61% of Schwab revenue comes from net interest income with most of the rest coming from asset management fees according to Schwab’s most recent 10-Q. Forward momentum Forward momentum SPONSOR CONTENT FROM But what’s less widely known is that Schwab makes more than 100% of its income and cash flow from one business — net interest income. I estimate that without net interest income, Schwab’s third-quarter 2019 YTD pretax income would have been a $1.1 billion loss rather than the $3.7 billion income it reported. A Schwab spokesman declined to comment on my estimate. That is to say, it’s virtually riskless arbitrage of paying clients practically nothing on cash sweep accounts and buying investment grade securities yielding far more. Schwab expenses are nearly all related to its legacy businesses of asset management and trading. The marginal costs of paying clients little on their cash and investing in investment grade securities is next to nothing. According to the Schwab 10-Q, it has paid clients an average of 0.39% annually on $213.1 billion of bank deposits while earning about 2.88% on those assets for the first nine months of the year. Schwab does have about $30.6 billion of other funding sources that bring the average costs up to 0.45% annually. The spread, referred to as net interest revenue, has been increasing over the past few years. What this means is that more than 100% of their profit comes from paying clients little on their cash and safely investing it investment grade securities in a nearly riskless arbitrage-like manner. Thus the original discount brokerage firm is no longer in the brokerage business and even the asset management business is a money loser designed to attract more cash to create more profit. Schwab smashes two paradigms This business model allows Schwab to smash two paradigms often taught in business schools. First, a business needs to compete on either price or quality but not both. Schwab has unseated Vanguard as No. 1 in satisfaction, according to J.D. Power, while having lower or no fees for trading — or even its zero-cost robo platform, the Intelligent Portfolio. I have found Vanguard’s website to be complex and unintuitive and have had several clients complain about service. Some have just given up using it. By contrast, Schwab’s website is very simple and intuitive and has 24/7 telephone customer service. Schwab is the clear winner in both quality and low price. The second paradigm: It’s okay to have a loss leader and sell a product below cost to build a pipeline of revenue elsewhere. Polaroid famously sold their camera below cost to build an annuity on profitable film sales. Gillette sold razors below cost to create a predictable cash stream selling profitable razor blades. Polaroid was in the film business and Gillette in the razor blade business. I have found Vanguard’s website to be complex and unintuitive and have had several clients complain about service. So Schwab is actually now in the cash business, meaning it can sell asset management or brokerage services below cost. Yet it smashed this paradigm by not only giving product away, but actually offering to pay my clients to move money over to Schwab with a $2,500 acquisition award for over $1 million. Schwab has gone far past selling product below costs. Schwab’s brilliant TD Ameritrade acquisition While still awaiting regulatory approval, Schwab agreed to pay $26 billion for TD Ameritrade. Though that purchase price represented a 17% premium over its stock price, TD Ameritrade stock had previously dropped by 26% in one day as a result of Schwab’s announcement it was eliminating commissions. TD Ameritrade stock plunged more than Schwab’s after eliminating commissions because TD Ameritrade didn’t have the same opportunity when it came to cash. That’s because TD Ameritrade has a greater percentage of its revenue from commissions and has a contract with its largest shareholder, Toronto Dominion Bank, limiting earnings from cash for TD Ameritrade. But as part of the acquisition, Schwab renegotiated the insured deposit account sweep program for more favorable terms. And TD Ameritrade actually has a slightly higher percentage of client assets in cash than Schwab (11.7% vs. 11.4%) according to a Schwab document dated November 25, 2019, announcing the acquisition. Schwab estimates $3.5 to $4.0 billion in annual synergies with roughly half coming from cost savings. Presumably, most of the rest of the other half will be coming from increasing spreads on cash as a result of renegotiating the cash agreement with Toronto Dominion Bank, which will own roughly 13% of the combined entity with $5.1 trillion of client assets. That’s nearly as large as Vanguard. Fractional shares — perhaps the most brilliant announcement of all The announcement that got the least publicity may be the most brilliant of all. Schwab stated they would be launching a platform to allow more people access to stocks by allowing the purchase of fractional shares in a bid to attract younger investors. They have said they will launch this in the coming months. CLEARINGHOUSES/CUSTODIANS How to succeed in the low-margin custody business: Lightning Round with Schwab's Bernie Clark December 17, 2019 05:02 PM While I think this offering will expand equity access to younger people, I suspect Schwab has a different goal in mind — one that could make traditional indexing obsolete. This goal is free-to-low-cost automated direct index investing, and happens to fit perfectly with its cash spread model. Direct indexing refers to the strategy of buying all the stocks of a certain index like the S&P 500 or Wilshire 5000. This allows for tax-loss harvesting at an individual stock level, rather than at a fund-only level. This equates to even more tax-efficiency (though not tax-alpha as taxes will likely eventually have to be paid). It automates selling shares at losses and buying similar companies to avoid the wash-rule sale disallowing the loss unless waiting 31 days or more to buy them back. Some robo advisors such as Wealthfront offer this but at higher fees. They don’t allow fractional shares so they require larger client deposits to mimic a broad index. If Schwab launches direct indexing with smaller amounts of money using fractional shares, traditional index funds could become outmoded as far more tax-efficiency is gained with potentially even lower or no costs. But the brilliance comes from two sources. First, unlike whole shares of stocks, fractional shares cannot currently be transferred so switching costs are extremely high. One would have to liquidate those shares with capital gain implications. Second, dividends may not automatically be invested in fractional shares so Schwab will have created a spigot of cash flow going into their low-paying, high-profit, very low-risk deposit account program. Could I be wrong? Sure, but I have a lot of respect for Schwab and its disruptive strategies. The fact that they announced fractional shares on stocks but not ETFs supports the theory of doing this for direct indexing. When I asked a Schwab spokeswoman about my hypothesis, she declined to comment. Vanguard can’t duplicate The combined Schwab and TD Ameritrade entity would be almost the size of Vanguard. While other firms like Fidelity and ETrade can also make these huge profits from client’s cash, it’s not in Vanguard’s DNA to capture client cash and profit obscenely because its clients are also the owners. Vanguard differentiates from Schwab and notes its money market funds (including sweep accounts) yield so much more. A Vanguard spokesperson responded that “Vanguard has always put our investors’ financial outcomes first by sweeping brokerage account cash balances into higher-yielding money market funds with a low expense ratio. We will continue to take this client-first approach to cash sweeps, regardless of what others in the industry choose to do.” Regarding the possibility of Schwab offering ultralow-cost direct indexing with fractional shares, Vanguard responded “If we believe that there is an enduring investment case for the addition of an investment strategy, and a cost-effective way to implement it, we will consider it.”
I doubt it. The average Vanguard customer is not interested in trading. If they were, they would not have a Vanguard account.
That's probably true. But if one is simply dollar cost averaging into an index fund and the Vanguard ETFs have been commission free for a long time, then there's no reason to switch.