TD Ameritrade's (NASDAQ: AMTD) change to its list of commission-free exchange-traded funds (ETFs) shows how the brokerage industry, increasingly threatened by passive investing, faces a difficult choice balancing investors' wants with its need to generate a profit.
Trading commissions, once the industry's bread and butter, are trending down as the industry slashes prices and investors eschew stock picking for passive index funds and ETFs. That means brokers have to get creative with how they generate revenue, and commission-free ETFs are increasingly playing a role as a revenue driver for many of the industry's largest companies.
Swapping commissions for royalty-like fees
It wasn't all that long ago that brokers preferred stock traders to fund investors. That's because brokers historically earned a small, up-front commission on each trade, and stock investors trade far more often than fund investors. That has changed, however, as brokers pair up with fund companies to offer free trades on certain funds in exchange for their share of the management fees.
As trading commissions decline, brokers are turning to commission-free ETFs to generate more revenue. Image source: Getty Images.
Many know Charles Schwab (NYSE: SCHW) as a master of the business model. In the most recent quarter, Charles Schwab earned an average annual fee of 0.34% of assets on products in its Mutual Fund OneSource list, funds investors can invest in without paying a commission. It also booked an average fee of 0.08% on client assets invested in "third-party mutual funds and ETFs," funds on which it does not charge commissions to investors to buy or sell.
Charles Schwab can afford to give its clients no-commission trades on these funds because it stands to make a healthy profit from sharing in ongoing fees. Last quarter, the company generated $231 million of fee income primarily by incentivizing its clients to invest in other companies' funds and ETFs. In contrast, Schwab earned just $151 million in trading revenue, primarily from commissions charged on client trades.
This is the upside of a shift toward funds rather than active stock picking. After all, commissions are an irregular, transactional source of revenue, whereas the fees earned from mutual fund and ETF managers are a royalty-like revenue source that should only grow over time. As I wrote before the most recent salvo in the commission price war, commissions made up less than half of net revenue for the largest discount brokers. Recurring fund fees and interest earned on loans and client account balances are often the largest slice of the pie and are far more predictable than commissions, which ebb and flow with market volatility.