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ETFs' Free Trade Boost

BofA's offer of free online trades may force others to follow -- and end ETF commissions.
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The emergence of free online trading could have a huge impact on the exchange-traded fund industry.

A few weeks ago,

Zecco Holdings

announced it was launching zero-commission online

trades. Shortly after that,

Bank of America

(BAC) - Get Bank of America Corp Report

said it was going to offer the

same thing to customers with a combined $25,000 or more in their Bank of America accounts, including checking and savings accounts and CDs.

This could be a major boon for ETFs, because while they're constantly praised for their low annual expenses, transparency, tax efficiency and flexibility, investors have had to pay commissions to buy and sell them. This has alienated a large pool of people, particularly those who prefer to invest in small, regular increments and would get slammed paying $10 a pop in commissions.

"The commission costs were the last major wall separating ETFs and index funds," says Matthew Hougan, editor of indexing industry Web site

IndexUniverse.com.

"ETFs are a fraction of the broader mutual fund industry ... absent brokerage fees, ETFs are a better structure in many ways. I don't think many people argue about that anymore," he says.

Others to Follow?

Looking ahead, the real question is whether other companies will follow Zecco and Bank of America. If they do, and ETF commissions start to fade away, it could lead to substantially higher asset flows.

"I definitely think it could have an impact, particularly if other brokerage companies follow suit," says Hougan. He adds that some analysts predict ETF assets will hit $2 trillion by 2011, and if free online trading becomes standard, "we could see upside to that number, and quickly." ETFs had more than $360 billion in assets at the end of September.

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The widespread elimination of online trading fees also could cause ETF asset flows to shift more in favor of retail investors.

It used to be that institution money made up the lion's share of ETF assets. But that has been changing. In fact, while it's difficult to find good data on flows, many analysts estimate that retail money -- particularly from the adviser channel -- is far exceeding institutional flows.

"This will likely lead to more

ETF retail flows and more flow in general," says Hougan.

Allan Roth, founder of investment advisory and financial planning firm Wealth Logic, agrees that these developments could be big news for the ETF industry.

"

It suddenly makes ETFs appropriate for accumulation, since an investor putting in a regular monthly amount won't have to pay commissions," he says.

However, there are a few caveats that investors need to be mindful of -- and they're not inconsequential.

"No commissions does not equate to no costs," says Roth. ETFs, like stocks, have spreads between the bid and the ask price, so even if there are no brokerage fees, investors will have to pay the spread.

Also, unlike buying index mutual funds, where you can invest a specific dollar amount and receive fractional shares, ETFs have to be purchased in whole numbers of shares. For example, if you wanted to invest the sum of $1,000, you could do so with a mutual fund. But with ETFs, you would have to purchase a certain number of shares based on the price at which they are trading.

Finally, Roth warns investors to be mindful that, "There is no free lunch."

With the absence of commissions, Roth says, "Bank of America and other institutions offering 'free' trades expect to make money from the customer in other ways."

Hougan echoes the last point, saying, "Free does cost something." In this case, it's evident in the interest rates, he says.

The interest rates for Bank of America's money markets savings account and CDs are below industry standards, Hougan says. So this may not be a good deal for customers, as it could substantially reduce their yearly deposit income.

Hougan adds a final point: "ETFs are supposed to be long-term investments," so investors should also be reminded that "just because trading is free doesn't mean you should do it."