Charles Schwab & Co. may have joined the ETF party late in the game, but the discount brokerage is breaking new ground with expense ratios that undercut everyone else in the industry.

The low-cost gamble, which started in November 2009 with the launch of four equity ETFs bearing the Schwab name, quietly raised the stakes for Vanguard, the longtime venerated price chopper. Investors seem to be benefiting from the competition. When Schwab came out with one of its first ETFs, the U.S. Broad Market (SCHB) fund, its 0.08% expense beat the similar Vanguard Total Stock Market (VTI) by one basis point. Since then, both firms have lowered expense ratios on those ETFs by two basis points-certainly not a savings landslide, but enough to suggest that each is looking over its shoulder to see what the other is doing.

Rock-bottom expenses, along with commission-free trades on its lineup, have given the funds a running start. By the end of May, the 13-member lineup had $4.4 billion in assets, up from $1.2 billion a year earlier, according to the National Stock Exchange.

With over $120 billion in ETF assets custodied at the firm, the opportunity for expansion is huge, says Tom Lydon, the president of Global Trends Investments who also runs the Web site "As the largest custodian of ETF assets in the U.S., Schwab made the right strategic move to be competitive in this space. More advisors are shifting assets to ETFs, and they're being more tactical and opportunistic in their investment disciplines." About 84% of financial advisors who trade through Schwab use ETFs in their strategies, according to a recent firm survey, and about one-third plan to use more of them in the future.

Individuals were the first to home in on the new funds when they first came out, says Tamara Bohlig, vice president of product management at Schwab. Now, she says, financial advisors account for about half of all shareholders. "In the mutual fund world, advisors usually like to see a three-year track record, so the uptake on the ETFs has been much faster than we anticipated," she says.

Still, many investors aren't biting yet. "Advisors often take a wait-and-see attitude before they move in," says Bohlig. "But we think that the combination of low expense ratios and commission-free trades are going to resonate with a lot of them."

With its move into exchange-traded funds, Schwab has run the risk of cannibalizing assets from its own stable of equity index mutual funds, the first of which became available in 1991. The largest, the Schwab S&P 500 Index fund (SWPPX), has more than $11 billion in assets. The oldest member of the firm's indexing group, the Schwab 1000 Index fund (SNXFX), spreads a relatively plump 0.29% expense ratio over on a $5 billion asset base.

So far, though, there's little evidence of intra-family asset grabbing. Most of the new money for Schwab's ETFs come from individual securities sales or cash rather than the company's index mutual funds or its other mutual fund products, says Bohlig.
Schwab has an incentive to make ETFs the indexing format of choice for investors. Compared to mutual funds, exchange-traded funds are much less expensive to administer and easier to launch. They tend to attract larger investors than Schwab's index mutual funds, which have an investment minimum of just $100.

The ETFs typically draw more sophisticated individual investors and financial advisors, many of whom already trade on the company's brokerage platform. According to data provided by Schwab, the average order size of its ETF lineup ranges from $11,000 for its small-cap international product to $46,000 for a short-term Treasury offering.

But smaller investors could also be brought into the ETF loop, since the no-commission feature makes it more financially feasible to invest small amounts. It also paves the way for dollar cost averaging into the funds, which would be prohibitively expensive and cumbersome with a commissioned trade. But Bohlig sees little evidence of such small investor strategies in the ETFs, at least not yet.
Schwab is also focusing on exchange-traded funds because it plans to launch a 401(k) platform that offers them as the exclusive investment choice. This plan package, scheduled to become available to employers in 2012, could dramatically boost market share for the Schwab ETF offerings if it catches on.