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Fee battles heat up, while SEC pilot finds few friends

NYSE Group President Stacey Cunningham

For exchange-traded funds, the battle for basis points has turned into a trade war.

At the recent Inside ETFs conference in Hollywood, Fla., trading and liquidity matters grabbed attention away from the yearslong focus on reducing expense ratios.

Moves by the brokerage units of Charles Schwab Corp. and Fidelity Investments to expand their commission-free ETF offerings to more than 500 offerings each could ultimately contribute to putting a floor under ETF fees.

Another topic of conversation was the Securities and Exchange Commission transaction-fee pilot, which could potentially put similar ETFs on different sides of a liquidity incentives experiment.


For years, ETF issuers liked to claim that their products were bought not sold, but that mantra no longer holds for a market of more than 2,200 listed products in the U.S.

Now brokerage firms are expanding the power of their platforms by striking further deals with ETF issuers to offer their products commission-free. Though the terms are not disclosed on an issuer-by-issuer basis, the deals usually include a set-up fee and a percentage of assets in the commission-free products on the brokerage platform. These fees are paid by the manager, not by the fund.

The power of the commission-free supermarket focused on advisers was first tested by TD Ameritrade Inc. in October 2010. Earlier that year, Fidelity entered into an exclusive partnership with iShares by BlackRock (BLK) Inc. (BLK) But E-Trade and Charles Schwab pioneered the manager pay-to-play model in 2011 and 2013, respectively.

But in October 2017, TD Ameritrade realigned with State Street Global Advisors and its revamped lineup of portfolio building (and reduced price) SPDR ETFs, pushing aside several iShares and Vanguard products. And by August 2018, Vanguard dropped commissions on all ETFs except those focused on daily returns using leverage. (According to a Vanguard spokesman, despite the removal of trading commissions, "roughly half of our retail brokerage participants that hold ETFs didn't place a single trade in 2018.")

The politics of these programs has become increasingly competitive for both issuers and brokers. While institutional users of ETFs won't be directly affected, the additional incentive of free trades for retail investors and their intermediaries could help to attract assets and liquidity for some products.

For example, ETFs in Schwab's OneSource program ended 2018 with $115 billion in program assets and $22.8 billion in flows, according to a company spokesman.

"It's just another consideration in how you build your expense ratio," said Ed Rosenberg, Chicago-based senior vice president and head of exchange-traded funds at American Century Investments, which managed $163 billion, including $87 million in ETFs.

Transaction fee

On the other side of ETF trading discussions are the various pricing and incentive schemes used by securities exchanges' maker-taker and taker-maker models. In an interview on stage at the ETF conference, Stacey Cunningham, president of the New York Stock Exchange, highlighted the sensitivity in the ETF business over the proposed SEC transaction fee pilot.

"We are challenging the SEC's transaction fee pilot in the federal court to protect our publicly listed companies, investors and the free-market principles that are core to our values," Ms. Cunningham said later through an NYSE spokesman.

The pilot, which will apply to some stocks and ETPs with average daily trading volume more than 30,000 shares and a $2 or higher price, will reduce or remove rebates for a select group of securities. This live experiment is designed to study how much the current model for adding or removing liquidity actually affects pricing and spreads.

ETF issuers and other market participants expressed concern last year in letters to the SEC that similar products trading on opposite sides of the pilot threshold could be unduly affected. The SEC did not adjust the treatment of ETPs for the pilot in its final rule published in December.

In mid-February, each of the major U.S. exchanges filed a petition in the U.S. Court of Appeals for the District of Columbia Circuit to hold the rule as unlawful.

Regarding ETPs specifically, however, the exchanges have spent years experimenting with differentiated listing and rebate models for ETP issuers and market makers in order to attract their business and tighten spreads.

Morningstar's Mr. Johnson said that he's generally been skeptical of incentive schemes designed to kick-start liquidity for smaller ETFs. "If issuers build funds that investors want, the liquidity will come," he added.