In a move to remain competitive in the uncertain economic environment, Charles Schwab (NYSE:SCHW) announced a drastic cut in fees for 15 proprietary exchange traded funds (ETFs) on Friday, September 21.  The company slashed operating expense ratios (OERs) collected from customers for managing administrative burden related to the funds for each of its Schwab ETFs. The move is designed to attract investors and follows Blackrock’s (NYSE:BLK) announcement that it plans to reduce fees for some of its iShares ETFs. Although this might help lure customers, the price cut might result in reduced profitability. We discuss below the effect that this development might have on Schwab’s stock price.
Our price estimate for Schwab is $14, in-line with the current market price.
Like fellow online brokerages Ameritrade (NYSE:AMTD) and E*TRADE Financial (NASDAQ:ETFC), Charles Schwab has been suffering from a decline in investor confidence in the U.S. Trading activity for the company has been suppressed this year with Daily Average Revenue Trades (DARTs) falling 31% in August compared to the same month last year. (See Online Brokerages Rely On Assets Consolidation As Investor Confidence Remains Low for more details on the firm’s performance in August) The company is prioritizing the consolidation of client assets under management.
ETFs have been quite popular among investors as they track stock and bond indexes and offer greater cost and tax efficiency than mutual funds. Net inflow for ETF bond funds in the second quarter of 2012 was around $70 billion, according to Lipper, a subsidiary of Thomson Reuters that maintains fund data.  Schwab started offering ETFs in November 2009 and acquired Windward Investment Management, an ETF model portfolio provider, in 2010 to help sales. Client assets for Schwab ETFs stood at $7.2 billion at the end of August 2012.
BlackRock and Vanguard Group, Schwab’s main competitors in the market, have been accumulating assets in the last few months. Until Schwab’s cut, the Vanguard S&P 500 ETF was the lowest-cost product in the market with an OER of 0.05%. To compete, Chuck cut prices for two of its most popular products, the Schwab U.S. Broad Market ETF and the Schwab U.S. Large-Cap ETF, to an OER of 0.04%, now the lowest in the market. In fact, the price of Schwab’s products is now the lowest in the respective Lipper categories. The weighted average OER for all 15 Schwab ETF offerings dropped from 0.13% to 0.08%.
With competitive pricing, we expect Schwab to attract investors to its propriety fund offerings. Although assets under management in Schwab ETFs only account for 2% of the company’s total assets under management, the price cut will help it keep pace with the industry and lure new customers. We currently forecast proprietary fund assets to breach $300 billion by the end of our forecast period. There is a potential upside of 10% to our price estimate should the growth rate exceed our expectations, driving total proprietary fund assets beyond $600 billion. You can gauge the effect of a change in our forecast by modifying the interactive chart below.Notes: