How zero-commission trading could challenge ETFs

Widespread adoption among discount brokerages could open the door for more customized diversification

How zero-commission trading could challenge ETFs

Whether you believe that the widening adoption of zero-commission trading is a gift to investors or a potential Trojan horse, there’s no question that it holds considerable ramifications for the discount brokerage industry. And assuming it catches on among a wider base of users, there could also be implications for the ETF industry.

“It seems that widespread commission-free trades could lead to broader adoption of direct indexing,” said Forbes contributor Simon Moore in a recent column.

Direct indexing has been described by some as the next step in portfolio management, with considerable potential for advisors looking for ways to get better customization and tax management. Rather than settle for popular benchmarks offered by index-based ETFs — broad exposure to the S&P 500, say — investors can construct customized portfolios of stocks, cutting out certain names and adding others as needed.

“Today, direct indexing is a good idea in theory, but potentially costly in practice,” Moore said. Those implementing a tailored index through a brokerage account, he noted, would face significant expenses as trading costs add up.

That’s one reason why the approach has been considered more feasible for institutional players and other investors with large accounts. As Moore noted, there are providers that already offer direct indexing services, but primarily for their wealthier clients.

Read also: Why traditional indexing isn't ready to be dethroned

With commission-free trading, the barrier to Main Street investors will be substantially removed. “With some relatively simple trading processes, which can be delivered through software, you can build an ‘ETF-like’ vehicle that is custom for you and is potentially more efficient from a tax standpoint,” Moore said.

It’s likely too soon to consider no-commission trading as an ETF-industry killer. ETF fees are continuing to decline, with index-based products being particularly low, so they are still appealing to the cost-conscious. And users of commission-free trading may experience drawbacks in terms of a decline in service, decreased product choice as firms consolidate over time, and a host of other aspects.

“How fast such services evolve and what the fully-loaded costs are remains to be seen, but the consequences for the ETF industry may not be positive,” Moore said. “Just as ETFs have seen rapid growth at the expense of mutual funds as a lower cost substitute, now direct indexing may take share from ETFs.”

Follow WP on Facebook, LinkedIn and Twitter