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Commission-Free ETFs at Canadian Discount Brokerages: A Clever Lure or a Good Deal for Investors? Part 1

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June 25, 2013

Published June 25, 2013 04:45 AM

Table Of Contents

    Key points

    Every day increasing numbers of self-directed investors are either turning to exchange traded funds (ETFs) to meet their investing goals or are learning more about how ETFs could help lower their investing costs.   Given the interest in these products by self-directed investors and the commission costs that are associated with buying and selling ETFs, Canadian […]

    Every day increasing numbers of self-directed investors are either turning to exchange traded funds (ETFs) to meet their investing goals or are learning more about how ETFs could help lower their investing costs.   Given the interest in these products by self-directed investors and the commission costs that are associated with buying and selling ETFs, Canadian discount brokerages have not only taken notice but have also sought to leverage this interest to their benefit.

    In the first of this three-part series, we briefly review the landscape of commission-free ETF trading in Canada. In part two we’ll look at what types of “commission-free” ETF trading options investors have as well as provide investors with several tips to keep in mind when considering these types of ETFs with a discount broker.  Lastly we’ll be taking a look at each discount brokerage’s commission-free ETF offering in detail to see what the pros and cons are of each.

    It’s so Hard Being Popular

    The case for investors embracing ETFs is relatively simple to make. Essentially, with ETFs investors get most of the benefits of a mutual fund (the two primary ones being professional management and diversity in composition) but at a fraction of the management cost.  Beyond the diversity and low management costs of ETFs, one of the biggest attractions for many investors has been the fact that ETFs, unlike their mutual fund counterparts, trade on stock exchanges the same way ‘normal’ stocks do.

    The freedom to buy or sell them short, to take options on ETFs and to enter and exit with relative ease has meant that investors of all kinds have a very versatile tool in their wealth creation toolbox to work with.

    Ironically, it is the popularity of ETFs that might be their undoing.  Data from the Canadian ETF Association (CETFA) shows that ETF landscape in Canada contained 257 ETFs from 6 distinct providers as of May 2013.  While their data does show strong demand and interest in ETFs with self-directed investors as well as with institutional investors, a recent article about the state of ETFs suggests that the ETF craze might be plateauing. Data from the US suggests that the sheer number of ETFs may have exceeded the interest and capital that can be allocated to them.

    In short, it appears that there are hints of an oversupply of ETFs relative to demand for them. The consequence  is a predictable downward price pressure and intense competition.

    Why Discount Brokerages Have Gone Commission-Free

    The freedom to trade ETFs as one would trade a stock has also meant that, like stocks, trades are subject to regular trading commissions from discount brokerages.  With the ability to trade in so many different ways, both active and passive investors can trade these instruments to suit their particular needs and strategies. For discount brokerages, the popularity of ETFs with investors has meant another possible revenue boost from trading commissions these instruments would generate.

    In 2011, that strategy for discount brokerages was upset. In that year Scotia iTrade significantly raised the stakes for other discount brokerages in Canada by offering commission-free ETF trading to investors. It wasn’t too long before the competitive nature of the discount brokerage industry forced others to join in, including Qtrade and Virtual Brokers.

    Fast forward to 2013 and there are (at the time of writing this piece) five Canadian discount brokerages who offer commission-free ETF trading of one type or another. They include:

    One of the obvious questions that comes to mind is: “why, in the face of such popularity with investors, would any discount brokerage offer ETFs to investors commission-free?”

    The answer seems to have more to do with the competitive ETF landscape rather than any warm & fuzzy feelings discount brokerages may have towards their clients.

    The cutthroat world of ETF providers has become so incredibly competitive that in order to encourage investors to choose particular funds, ETF providers are willing to pay marketing fees to the discount brokerages to attract the volume of investor capital that is critical to their business model.

    On the surface, the alliance between the ETF providers and discount brokerages seems sensible, at least in certain cases. The former makes more money with larger assets under management whereas the latter could receive more predictable revenues from marketing fees than from investors deciding to trade or not.

    Ultimately, both the discount brokerages and ETF providers still have to make money which explains why the most popular ETFs still have to be paid for in some fashion and why those that are commission free to buy and sell aren’t necessarily the ones investors seek out the most.

    In the next part of this series, we dive into what kinds of commission-free ETF choices are currently offered by discount brokerages as well as several tips for investors considering these features as part of choosing a discount brokerage.