Schwab’s new ETFs solve one critical problem in the ETF market, but they won’t take over the world. At least not for a while.

I’ve been thinking about the Schwab ETF launch all week, trying to figure out if it’s a game-changing event or an overblown bit of marketing. I think it’s a bit of both.

The big news, of course, is that Schwab is entering the ETF market and breaking new ground on fees. It has launched four ETFs that offer the lowest expense ratios in the world: As low as 0.08 percent for U.S. broad market exposure. The new Schwab Total Market ETF (NYSEArca: SCHB) and Schwab Large Cap Equity ETF (NYSEArca: SCHX) are now the lowest-cost mutual funds available to retail investors.

What’s more, Schwab is offering zero commissions for Schwab customers who buy or sell the ETFs.

That’s a big deal. Commissions are a huge hurdle

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Direct from Schwab's New York ETF launch event, Matt Hougan and Dave Nadig discuss the "free-to-trade" ETF concept.

It’s one thing to love a product for its innovation, but another to blanket the world with that love without highlighting the real problems.

Paul did a great job covering the credit risk, although I tend to side more with Matt on that part of the argument. But my real problem with ETNs is trading them.

We can argue about chicken/egg all you like, but the reality is this: The very most interesting ETNs, the ones that would be tough to deliver in an ETF package, are the ones with the worst trading problems. Right now, the top of the league table in “holy cow, look at the spreads” is dominated by ETNs.

 

Name

Ticker

Assets ($,mm)

Average Spread

Claymore US

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In his latest blog, Matt sings the praises of ETNs and argues that the risk of losing money is “vanishingly small”.

Matt’s argument is that “most ETNs offer daily redemptions at net asset value, meaning that (even ignoring the quoted market) an investor of size (50,000 shares in the case of iPath ETNs) can sell out of the product within 48 hours and get the full net asset value of the note from the issuer.”

In other words, even if you become concerned about the credit risk of the issuer and there is insufficient liquidity in the secondary market for you to trade, you can get out of a position by selling it back to the ETN issuer.

I agree with Matt that the tax treatment of ETNs gives them a huge advantage for US investors (ETNs are taxed at long-term capital gains tax rates and only on a deferred basis

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Exchange-traded notes are like the forgotten stepchildren of the ETF industry: unloved and overlooked. Investors (particularly taxable investors) are missing out.

According to the National Stock Exchange, U.S. ETNs had $6.9 billion in assets at the end of September. ETFs were literally 100 times more prevalent, with $697 billion in assets. That included $62 billion just in long commodity ETFs.

That’s just crazy. And it highlights investors’ irrational fear of the ETN product structure.

I remember when ETNs first came to market in 2006: Investors couldn’t get enough of them. Barclays Capital launched the iPath Dow Jones-UBS Commodity Index ETN (NYSEArca: DJP) and it quickly gathered assets.

The reason was simple: ETNs offered two huge advantages over commodity ETFs.

First, they promised perfect tracking. If you bought an ETN, you would receive the full return of the benchmark, minus the fund’s expenses. Period. That’s handy, since commodity ETFs have been more prone to tracking error

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Matt Hougan and Dave Nadig debate the pros and cons of exchange-traded notes, examining their tax treatment, issuer credit risk and the dearth of new products.

 

A new ETF giving access to Chinese A shares is to be launched in Singapore next month.

The United FTSE Xinhua China A50 ETF, to be offered by the asset management subsidiary of United Overseas Bank (UOB), will be the first China A-shares fund to be denominated and traded in Singapore dollars.

Chinese A shares are denominated and traded in Chinese yuan and listed on the Shanghai or Shenzhen stock exchanges. Historically, access to the A-shares market in China has been limited to Chinese nationals and qualified foreign institutional investors (QFIIs) approved by the China Securities Regulatory Commission (CSRC).

The FTSE Xinhua China A50 Index is designed to measure the performance of the 50 largest China A-shares companies, based on market capitalization.

ETFs tracking A shares are already dominant in the Asian market. The Hong Kong-listed iShares Asia Trust, which also tracks the FTSE Xinhua A50 Index, is the largest Asian ETF, with $6.7

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Matt’s ideas for fixing bond ETFs aren’t bad, but focusing on premiums and discounts is a mug’s game.

Matt, I know you love it when issuers come up with creative ways to game the arbitrage process to increase liquidity and narrow tracking error, but the problem here is really more fundamental. The way I see it, bond ETFs will always be fighting two uphill battles.

The first problem is just woolly thinking with regard to premiums and discounts. The reality is that at any given point in time, the true NAV of any portfolio (ETFs included) is a moving target. The way I think about it, there are actually three claimants to the title of “true NAV”:

There’s the rollup of all the “bids” in the underlying securities. This would be what the ETF basket would sell for if you could shove the portfolio through the top of the market. There’s the rollup of ...

MARKET COMMENT October 22, 2009 DRIVE-THRU SOUP KITCHEN 2009 So, what the hell was yesterday about anyway? It lends credence to the idea of heavy liquidations in Galleon’s hedge funds since there don’t appear any other credible ideas—but, I’m open to suggestions. The rally today was led by earnings from McDonalds, Travelers and 3M. The 2:15 PM Buy Program Express arrived on time to squeeze shorts from yesterday’s closing debacle. The buy programs were stimulated by little follow-though selling from yesterday and the LEI coming in “better than expected”. Ignored in the enthusiasm was a lowering of the previous LEI report. We finally got big volume today on an up-day with dip buying and earnings optimism. Breadth was quite positive. ...

You want to fix bond ETFs, Dave? Here are a few simple ideas.

Idea No. 1: Optimize The Creation Basket (At Least Sometimes)

The first idea is drawn from the way Vanguard manages its bond ETFs. You touched on this in your blog, but you really didn’t get to the core of what makes their bond ETFs interesting.

In the Vanguard structure, ETFs are one share class of a broader mutual fund. One advantage of this, as you mentioned, is that an ETF like the Vanguard Total Bond Market ETF (NYSEArca: BND) gets to tap into a much broader portfolio of securities. While a fund like the iShares Barclays Aggregate Bond Fund (NYSEArca: AGG) holds 247 bonds, BND is part of a larger mutual fund that holds more than 3,000.

That’s good in general: The more diversified portfolio, the better. But it’s good in a more interesting way, too.

Vanguard can’t ask Authorized Participants

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