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E*Trade Rebates May Be a Mixed Blessing

The broker's plan to give clients a kickback on fund fees might not benefit the bottom line.

Wall Street is full of payoff schemes, but for once, individual investors may be the ones to cash in, if

E*Trade

(ET) - Get Report

has its way.

The online broker recently announced plans to distribute part of the fees it receives from mutual fund companies to the company's clients who invest in the funds through E*Trade. The company plans to begin issuing the rebates by the end of the year. All clients will be eligible for the rebates, provided they maintain various account minimums and purchasing requirements.

The idea is a first among online brokers, and the move could inspire E*Trade's competitors to follow suit. In a competitive environment for discount brokers, bringing in new accounts is becoming more cutthroat, which means costs could start falling noticeably for fund investors. But while E*Trade's plan could be a small boon to fund buyers, the benefit to the company's bottom line is a little less clear.

The plan will certainly cost E*Trade, as the company will forfeit part of its current revenue stream. If the move doesn't attract a significant number of new fund buyers, it could lower the discount broker's earnings. E*Trade declined to provide details on the size of its fund platform or on how much it charges the average participating fund. It also wouldn't disclose the fund platform's total revenue or the costs involved in operating it.

E*Trade is offering the rebate to increase the customer base for its so-called fund supermarket, a one-stop shop where investors can buy and sell mutual funds -- often with no transaction fees -- through the same brokerage account that they use for buying stocks, bonds and options. According to the company, E*Trade has $57 billion in client assets, including assets invested in funds in its supermarket. In comparison, industry leader

Charles Schwab

(SCH)

has almost $200 billion in fund supermarket assets alone, according to its financial reports.

How It All Works

Fund supermarket customers primarily buy no-load mutual funds. At a discount broker, no-load funds fall into two camps: those that are available for no transaction fee and those that require investors to pay commissions when they buy or sell. In both cases the discount broker makes money.

If a fund pays the broker a fee on assets bought through the supermarket, the fund will be available to brokerage clients for no fee, which can help boost sales. For instance, if an E*Trade customer puts $10,000 into a Janus fund, E*Trade may get $25 in fees from Janus each year the account stays open, assuming Janus pays E*Trade 0.25% of the assets. Brokers charge funds anywhere from 0.20% to 0.40% a year. Vanguard and other lower-fee funds don't pay brokers, so investors who buy through E*Trade must pay a commission of $24.95 when they buy or sell shares in the fund.

The fees paid to the broker from the fund family generally come out of the 12b-1 fees that the fund itself charges all shareholders each year regardless of how they bought the fund.

So how much will investors get from E*Trade's planned kickback? E*Trade intends to reimburse 50% of the fees it collects from funds to the fund buyer. In an example the company uses in a press release, an investor with $500,000 in funds could theoretically receive $1,000 a year in fee reimbursements. This assumes that the $500,000 comes from funds that pay E*Trade a fee and that the funds pay 0.40%, an amount E*Trade doesn't likely receive from many funds.

Lou Klobuchar, president of E*Trade Securities, declined to divulge the amount that the typical E*Trade client has in funds. He also wouldn't disclose the average percentage fee that E*Trade now gets from funds. He declined to say how large the fund supermarket is as well. Klobuchar did note that the average E*Trade customer has about $18,000 with the company.

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In practice, E*Trade's kickback plan won't be nearly as lucrative for an E*Trade investor as the example given by the company, but could still make the E*Trade supermarket one of the most attractive for investors.

How much a fund investor can get back depends on how much money he or she has invested in funds that pay E*Trade and what those funds pay. More typical than the example above would be an investor with $50,000 in fee-paying funds, with the average fee paid by the funds to E*Trade at 0.30%. In such a case, the fund investor can expect a check for $75 a year.

By kicking back these fees, E*Trade will be the cheapest place to buy certain funds, and will mean that investors can end up paying less to invest in a fund through E*Trade than it would cost to buy the fund directly from the fund company. For example, an investor buying directly through Janus won't get the kickback in fees that he or she would get from investing in Janus through E*Trade.

Some fund companies might not appreciate E*Trade's creating a disadvantage to buying their wares directly, as the fund companies can lose touch with individuals and can't readily promote new offerings to them. If fund investors who have bought directly want to transfer their account to E*Trade to get the kickback, fund companies could revolt and sever ties with E*Trade, as such a move by fund investors would lower profit margins for the fund company.

"We're all for reducing expenses for our shareholder, and if E*Trade wants to work with us, we're willing to pay them less," said Jim Atkinson, CEO of Guinness Atkinson Funds. Atkinson is perplexed at how E*Trade can reduce its cut of the fees when Schwab has said to fund companies that its recent fee increases for funds were due in part to rising costs. Klobuchar said only that E*Trade has a history of low-cost structures and initiatives.

How much will the fee kickback cost E*Trade? Assuming that the fund supermarket has $5 billion in client assets in funds that pay E*Trade and that E*Trade charges the average fund 0.25% of assets, E*Trade's revenue would be $12.5 million per year. Assuming costs to run the supermarket run 0.10% of total assets in the supermarket, E*Trade generates profit from its supermarket of $7.5 million per year. While total revenue from the fund companies' fees is likely less than 1% of total revenue at E*Trade, $7.5 million in marginal profit is noteworthy, as E*Trade's total earnings last quarter were just $13 million. Of course, if the move brings in assets, it could be profitable for the company. E*Trade had no comment on the calculations.

Hurdles Ahead

Klobuchar says E*Trade intends to offer kickbacks on some types of load funds known as level-load funds, but not on front-end or back-end loads. This move could create a sticky situation with regulators. For instance, the National Association of Securities Dealers, or NASD, probably doesn't want brokers giving commissions back to individuals, as it could undermine the brokerage industry's efforts to keep commissions high and semifixed. The NASD didn't return numerous calls to discuss the matter.

Also of concern to E*Trade is the fact that the lower-cost fund supermarkets, such as those of E*Trade and

Scottrade

, haven't grown to be a significant portion of the total assets in fund supermarkets, due to the dominance of Schwab and

Fidelity

. Fund supermarket fees are complicated, and offering rebates and fee reductions doesn't automatically lead to new account growth.

For example, Schwab can be the most expensive fund supermarket for investors because it charges higher commissions than other brokers to buy and sell funds that aren't on its OneSource NTF platform, yet it remains a leader in investor assets.

Jonas Max Ferris is co-founder of

MAXfunds.com, a fund research and analysis company, and partner in an investment advisor offering managed accounts in mutual funds. He welcomes column critiques, comments or baseless accusations at

jferris@maxfunds.com.