Vanguard Declares War Against Custodial Platform Shelf-Space Distribution Agreements

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everyone. Welcome to Office Hours with Michael Kitces.

For today's Office Hours, I want to talk about what I think is actually the biggest industry news of the year that broke just earlier this week, the significance of which I think has largely been overlooked by the media. And the news I'm talking about is the announcement from Vanguard that starting in August, next month, it will begin offering commission-free ETF trading through its Investor.Vanguard.com online brokerage platform on a whopping 1,800 ETFs. Not just its own ETFs that were actually already mostly available commission-free, but virtually all ETFs, including those from all their major competitors like BlackRock, State Street, and Schwab.

In fact, Vanguard said that the only ETFs that won't be available for free are their inverse and leveraged ETFs, given that, in their view, and I would certainly agree, they're really more speculative trading vehicles in the first place and not so much long-term investments. They want to make this available on the long-term investments. And the ETFs they're going to be making available at no trading fees are on top of the 2,500-plus mutual funds that Vanguard already does without trading fees.

From a purely competitive perspective, the media was quick to jump on this and point out like, "Wow, Vanguard is offering 1,800 ETFs on a no-transaction-fee basis, which is a much wider range than Fidelity's platform is 95 ETFs on their NTF platform, Schwab's is about 200, TD Ameritrade's is about 300. So Vanguard will by a rather sizable, like, 6X to 9X margin have the widest range of ETFs available on a no-transaction-fee basis and puts a lot of pressure on other online brokerage competitors to step up their game and offer more options."

But the idea that Vanguard will have a better or more competitive platform for no-transaction-fee ETFs because it offers 1,800 of them while others only offer a few hundred I think actually entirely misses the point of why this is such big news. Because from the consumer perspective, the truth is that most people are only going to buy a handful of go-to ETFs in the first place. That's why the overwhelming majority of ETF assets already are concentrated in just a few hundred funds from, like, a half a dozen ETF providers. So arguably, the last 1,000 or 1,500 of the 1,800 ETFs that Vanguard is going to offer are largely irrelevant for most investors anyways. The real news and the real significance of the announcement comes from understanding why it is that all the other platforms only offer 100 or 200 or 300 ETFs on their no-transaction-fee platforms in the first place.

Shelf-Space And Revenue-Sharing Agreements For NTF ETF Platforms [Time - 2:54]

So, a little bit of historical context here. The first no-transaction-fee online brokerage platforms really got going in the 1990s. Pioneered by companies like Schwab, with their OneSource program, that basically built this giant online supermarket of mutual funds. Now, of course, brokerage firms still have to make money, but the key insight at the time was that, rather than charging transaction fees to purchase funds, which they realized actually wasn't going to be a good deal for mutual funds anyways because they tend to be bought and held and not actively traded the way that stocks and bonds are, Schwab's OneSource program took this 12b-1 shareholder servicing fee for the funds instead, with a plan to make money over time on the servicing fee for buy-and-hold investors instead of making it up on the trading volume.

And this was further bolstered by what are called sub-transfer agent or sub-TA fees, which were paid by the mutual funds to the brokerage platforms for all the handling that they were doing around fund record-keeping, tracking purchases and sales, calculating dividends and gains distributions, and so forth. So the mutual fund NTF platforms made no money on the upfront trading fees because they made their money on the ongoing 12b-1 and sub-TA fees instead, which works well when you've got long-term investors.

Then ETF showed up. And from the investor perspective, an ETF felt like a mutual fund. Sure, it traded intraday instead of just once a day at the end and there were some differences in tax treatment, but it was a pooled investment fund like other pooled investment funds like mutual funds. And so, even though ETFs traded intraday like stocks, investors increasingly wanted to buy them like mutual funds, and without the transaction fees.

And the problem is that ETFs don't have 12b-1 fees or sub-TA fees to pay the brokerage platform. So when online brokerage platforms wanted to offer ETFs under a no-transaction-fee platform, they needed a way to get paid. And the way they got paid was they simply negotiated direct distribution agreements with the ETF providers and said, "Look, if you want to be listed on our NTF platform, you've got to pony up, you've got to pay, either as a revenue-sharing agreement, if you want to be on our platform, you have to pay 10 or 20 or 30 basis points for all the assets on our platform," or what were effectively shelf space agreements, where the ETF providers didn't pay basis points, but everyone did the math. If the ETF provider had $1 billion in the NTF platform, the brokerage firm said, "If you want to continue accessing the platform, you've got to pay us 1 million bucks." And 1 million bucks was 10 basis points and $1 billion in the platform. So it was a shelf space agreement and not a basis point agreement, but it was really calculated to be equivalent to basis points.

So this way, brokerage platforms could continue to make their basis points or basis point equivalent providing no-transaction-fee ETFs the same way they did with their transaction fee mutual funds. And while the ETF doesn't literally have a 12b-1 fee or a sub-TA fee, functionally, the end result is the same. The fund company has to pay to distribute the ETF, which increases the expense ratio of the ETF, because the money has to come from somewhere. And so for most consumers, it was really a distinction without a difference. You could buy a mutual fund that paid an NTF platform through 12b-1 and sub-TA fees, or you could buy an ETF that paid the NTF platform fee through a revenue-sharing distribution agreement. End result, though, was that the expense ratio of the fund was lifted up for the consumer so that the custodial platform could make their dollars.

And then Vanguard came along.

How Vanguard (And DFA) Bucked The Trend Of Paying For Distribution [Time - 6:16]

Because, the unique thing about Vanguard relative to virtually the entire remainder of the ETF marketplace, is that they're notorious for not paying dollars under the table to get onto these NTF platforms. They just don't pay the way that everybody else does. Now, 5 to 10 years ago when a lot of these platforms were being built, Vanguard was still not nearly as dominant in the ETF space as they are today. They were popular, and so a lot of companies allowed Vanguard in because it was good name recognition, it helped to validate the platform to say they offered Vanguard funds, but there was always tension because technically, every investor or advisor that actually chose the Vanguard ETFs in the NTF platform was sticking it to the custodian or brokerage firm because they weren't actually getting paid on those assets.

But as Vanguard continued its meteoric rise over the past several years, that phenomenon has shifted from, "Sure, we'll include some Vanguard funds as part of our ETF lineup to give it more credibility, and we'll just hope that most investors use a lot of other funds that pay us as well," to something that's more like, "Oh, crap, Vanguard is attracting so much in assets to our NTF ETF platform that it's killing the profitability of our platform, we've got to swap them out for other ETF providers who will pony up and pay." And that's why last year you saw the big announcement when TD Ameritrade completely redesigned their NTF platform, which they billed as a great expansion of their NTF options, but reality was structured to kick Vanguard out, because Vanguard wouldn't pay on the back end, and they had to substitute in other ETF providers who were willing to pay to play.

And it's a phenomenon that's been happening with Vanguard mutual funds for a long time as well. This is why most RIA custodial platforms charge more to trade Vanguard mutual funds than any other, because Vanguard doesn't give them the 12b-1 and sub-TA fees that the others do. DFA is also known for not paying on the back end, which is why they are more expensive to trade. And this is even why you saw the big announcement last year that Morgan Stanley decided to kick Vanguard mutual funds off their platform entirely because Vanguard wouldn't give them the back-end payments.

Now, most fund companies that refuse to pay to play distribution game end up suffering. This is why it is so entrenched. Because they just don't have any other way to get their funds out there. So they're stuck mired in obscurity. Or even if they can get known a little, it's so hard for most fund companies to become so known and so popular that consumers will choose to take that upfront transaction fee slap to the face just to have a chance to own that fund.

That's where Vanguard is somewhat unique in being able to get away with this because the Vanguard brand is so strong. And in part, because they really do make it up for the consumer by making their mutual funds and ETFs cheaper, and passing along that savings of what they're not paying in distribution payments to the consumer. So, you know, we as the advisor and the investor say, "Well, I'm willing to pay a little bit of a trading fee for Vanguard funds because I know I'm going to make it up in the long run on the lower ongoing costs. And, you know, it sucks to have to pay the upfront fee, but I can see it's a good deal in the long run."

Vanguard Declares War On Shelf Space Distribution Agreements [Time - 9:16]

And this is why it's such a big deal that Vanguard made the announcement this week that it's going to make virtually all ETFs available on its online brokerage platform. Because the real significance is not just that they're offering no transaction fees on 1,000 more ETFs than any other NTF platform, the significance is that they're offering a no-transaction-fee platform without requiring the same back-end shelf space agreements that all the other brokerage and custodial platforms require.

In other words, the latest move by Vanguard isn't a price war on ETF trading fees, it's declaring war on the entire model of asset managers being forced to pay back-end revenue-sharing and shelf space agreements to get onto the platforms in the first place. And Vanguard is doing it by saying, "Fine, we'll just make our own and not charge the asset managers what everybody else charges." That helps to explain why they got 1,800 ETFs onto the platform. It's pretty easy for an asset manager to say yes to that.

So in the near term, the headline is, "Vanguard is offering 1,800 ETFs with no transaction fees", which means I'm sure sometime in the next few weeks, Schwab or Fidelity or TD Ameritrade, or several of them will cut some more deals with ETFs or new ETF providers and send out a press release that says, 'Hey, we're expanding our lineup by another 100 or 200 or 300 ETFs as well, and we'll now provide opportunities for more than 98% of the investable marketplace with our free-to-trade ETF lineup.'" Because it misses the point.

The real significance here is not the breadth of the Vanguard lineup of no-trading-fee ETFs, because it doesn't take that many to get broad exposure in the market in the first place. We don't need 1,800 different ETFs to make a well-diversified portfolio. The significance is that they've created a platform to do it without layering in the same depth of back-end fees that the other platforms are charging to the asset managers in the first place.

And I want you to think for a moment about how this plays out from here. ETFs that pay these platform fees are compelled to increase their expense ratios to cover the cost, because the money has to come from somewhere. Except now if you're an ETF provider, you have a problem. Your ETF expense ratio is boosted artificially higher to compete on NTF platforms like Schwab and Fidelity and TD Ameritrade, but the higher expense ratio to cover the distribution cost on those platforms is reducing your competitiveness on the new mega-Vanguard platform, where Vanguard itself is probably going to kick your butt on the expense ratio because their expense ratios are not elevated for the back-end payments you're paying on the other platforms.

So what do you do as an ETF provider? My guess, you're going to see ETF providers start creating new series for their popular ETFs with those distribution costs stripped out. A new lower-cost version of their ETF specifically to go on platforms like Vanguard's no-transaction-fee platform, because they need the lower cost to be competitive, especially on a platform like Vanguard, which is known for its cost competitiveness.

But this causes a bifurcation in ETFs. Because what we're going to end out with are the equivalent of two share classes of ETFs: higher-cost share class ETFs that go into NTF platforms that require back-end or shelf space agreements, and lower-cost versions of the same ETFs that go to platforms like Vanguard's, or even any other platform where if you're just willing to pay a few bucks for an upfront trading fee, you get the lower-cost share class of the ETF.

Basically, it's going to recreate the multiple share class effect we now have in mutual funds, where there's a higher-cost version of mutual fund that get some distribution agreements in the NTF platforms, pushed up by 12b-1 and sub-TA fees, and then there's another lower-cost version of the same mutual fund that you can buy directly. All mutual fund share classes at the end of the day are derived from different payment distribution agreements to platforms.

And now the same thing is coming to ETFs, spurred by what Vanguard has done. And it creates an opportunity for us to choose whichever one is the lower cost in the long run. The NTF version for small clients where trading fee is prohibitive and we want to get that NTF platform, and then buying the lower-cost version directly, where the trading fee is smaller than paying the ongoing higher expense ratio. Which over time is really going to turn NTF platforms from free no-transaction-fee platforms into what's really just a fee-based wrap account where the transaction fees are wrapped into the ongoing basis points you pay on the platform. You can either pay directly as wrap fee or indirectly through the expense ratio or the mutual fund or ETF. But if you want the cheaper version, you'll be able to get it and separate out those distribution costs.

How Vanguard Profits In The War Against NTF Platforms [Time - 13:38]

In the meantime, you may be wondering how Vanguard itself can afford to do all this without actually earning the money that the other platforms earn, because obviously, Vanguard does need to run an economically viable business itself. But think about it for a moment from Vanguard's perspective. Vanguard gets more opportunities to consolidate a household's entire base of assets onto the platform at Vanguard in ETFs where they're already the market leader. I mean, how long do you think it is before investors consolidate their assets into Vanguard's offering of 1,800 no-transaction-fee ETFs and then decide that, "Hey, there's a Vanguard option version of what I've already got that's a little cheaper, why don't I just switch to the Vanguard version?"

In fact, Vanguard will essentially get to use this as on-platform market research. All they have to do is literally look into their own accounts, see what investors hold that Vanguard thinks they can replicate at a lower cost. And if there's enough of the asset opportunity, roll out a competing fund at a lower cost, communicate to all the investors on their platform, "Hey, we've just offered a lower-cost version of what you already own, would you like to make the switch? Click here." And it's a huge asset growth opportunity for Vanguard.

On top of that, Vanguard has Personal Advisor Services, their advisor platform where they give access to human CFP certificant to provide additional financial advice for a cost of 30 basis points. So even if Vanguard makes nothing on the ETFs that their clients hold from competitors that aren't Vanguard, they can make money on the Vanguard advice offering.

Which is just what I predicted last year, that eventually someone would break the existing paradigm by saying, "We'll give the investments away for free and just charge for the advice." And that's exactly what happens if Vanguard starts to gather assets on its no-transaction-fee platform. It doesn't make money on the back-end payments because they just upsell to Vanguard Advisor Services instead. So they'll make zero on the investments and 30 bps on the advice. Which is actually even better for them because at the end of the day 30 basis points on advice is way more revenue than 3 to 5 basis points that they charge on a lot of their ETFs anyways. And of course, there's still the opportunity that Vanguard advisor works with the investor, and then helps them to discover that there are some cheaper Vanguard alternatives for the things that they already own. It's a win-win-win opportunity for Vanguard even without making all those back-end dollars.

Implications For RIA Custodians And Financial Advisors [Time - 15:52]

So what are the implications on this for us as advisors? The bad news, I guess if you can call it that if you're in search of lower-cost solutions for your clients, is Vanguard does not have a full-scale custodial offering for RIA. So, as far as I'm aware, we will not have any way to directly access this kind of, you know, true no-transaction-fee platform for our clients unless we send them directly to Vanguard retail. And while we'll see if ultimately Vanguard makes a harder shift into the financial advisor business by actually offering custody and clearing services for RIAs, at this point, they seem content to have their funds distributed through other RIA custodians to reach advisors, and focusing their services on serving consumers directly, including financial advice directly for those who want to buy it from Vanguard Personal Advisor Services.

But even if Vanguard isn't going to become an RIA custodian any time soon, the ripple effects that are going to come from them basically declaring war on NTF platforms and all these hidden back-end shelf space agreements that are out there, it's a really big deal. In retrospect, I think this explains why just two weeks ago, E-Trade announced that they were adding 32 Vanguard ETFs to their own NTF platform. Because Vanguard probably told them, "Not only are we going to not pay you basis points to put Vanguard ETFs on your E-Trade platform, but we're going to open our own competing NTF platform. So if you don't allow us in the mix with your ETFs, we'll just take your customer and allow them to full mix of ETFs on our platform instead."

Similarly, I think this is really a slap in the face to TD Ameritrade that kicked Vanguard out of its NTF platform last fall, right before the Scottrade acquisition, and now instead of just losing money on Vanguard ETFs in the TD Ameritrade NTF platform, now TD Ameritrade is going to have to compete directly against Vanguard's own solution. I think they may have slightly underestimated the size of the hornet's nest they were kicking when they decided to kick Vanguard out.

And again, because the reality is that the expense ratios of so many ETFs are artificially inflated by all of these platform shelf space and revenue-sharing agreements that happen and all the ways that brokerage firms try to extract money from asset managers behind the scenes, if Vanguard's new NTF platform gets any traction, there's going to be immense pressure on asset managers to launch new versions of their ETFs that are lower-cost alternatives to strip out all these back-end payments, which will then become lower-cost ETFs that all of us can buy for advisors as well, even if Vanguard doesn't offer us the platform directly. Because once the ETFs are launched, they're out there, and that ever-decreasing ETF trading cost, you know, $9.95, $6.95, $4.95, as they go lower and lower, this just becomes a better deal for all of us to serve our clients as well.

And frankly, will pull even more assets away from NTF platforms because every advisor is going to do a map and figure out, "Is it cheaper to pay the upfront trading fee into the lower-cost fund, or to avoid the trading fee and just pay the higher-cost ETF instead?" You know, in essence, we're systematically wired to dismantle the profits of our custodians as cost savings for our clients, and now the game is on.

You know, even as Karin Risi said, who's Vanguard's own managing director of retail, you know, the way they frame this is, "Vanguard is driving down the cost of investing in ETFs." Not the cost to trade ETFs, the cost to invest in them, because this is actually about the back-end payments, not the upfront payments. And if it doesn't work, well, it'll be interesting to see if Vanguard does decide to take the process one step further and actually launch some kind of more full-service RIA custodial platform and expand this kind of less conflicted version of the NTF platform more directly to the advisor community.

Now, I do think it's important to notice, as we wrap up, that RIA custodians and brokerage platforms do provide a service and they do deserve to get paid. I am not at all advocating that we should be getting everything for free here. But the nature of NTF platforms with their hidden back-end payments that I'm not even sure all advisors and investors realize are there, presents real conflicts of interest between RIA custodians and their advisors, which we see play on situations like TD Ameritrade yanking Vanguard funds out of their NTF platform and causing an advisor uproar in the process.

In fact, my guess is that this new shot fired from Vanguard back at the back-end payments for NTF platforms will hasten us towards what I think is the inevitable conclusion that eventually, RIA custodians are going to have to charge their own basis point fee for custody services instead, rather than trying to squeeze all these back-end payments. So if a custodian says, "Look, we need to make 5 basis points or 10 basis points or 20 basis points," whatever it is on investor assets on the platform, rather than I think this quagmire of back-end payments and the whack-a-mole game that as advisors we play to try to game the system to bring the cost down for our clients, just let the RIA custodians charge that exact same custody fee directly for the real value they're providing, from trading and record-keeping, the technology and support services, it won't necessarily be more or less expensive. In fact, the custody fee could be restructured to deliberately match whatever the average basis points are that custodians already earn on advisor assets.

But by realigning the model, they can be in alignment with advisors and our clients, and actually focus for once on giving the best solutions because they're already getting paid, rather than trying to drive us or game us into higher-cost solutions to make their hidden but not really hidden fees. That's why most RIA custodians sweep client cash to proprietary money market and related bank entities that pay 0.5% or 0.1% or some literally zero, and Vanguard's online brokerage platform is going to sweep to a Vanguard money market fund that yields 1.82%. It's amazing what happens when companies reduce the conflicts between their own business model and the advisors and investors they serve.

But the bottom line here is just to recognize that the real news of the announcement is not that Vanguard is going to be offering 1,800 ETFs with no transaction fees while their competitors only offer 100 or 200 or 300. The real news is that Vanguard is fighting back hard against the industry practice of trying to extract back-end revenue-sharing and other shelf space distribution agreements by launching their own competing platform and focusing on other ways that they can make money that are more aligned to the consumer.

But in the process, I think is causing what ultimately may be a fatal disruption to the nature of the NTF ETF platforms that at the least are probably going to see a bifurcation of higher-cost and lower-cost ETF share classes and bring on a new wave of lower-cost ETFs. And at best will still slow the flows to higher-cost NTF platforms or still undermine the model that firms have to switch to a more transparent version of just charging the advisor or investor a basis point fee for custody and clearing and wrap and all the other services, and make themselves independent of all the conflicts that come from these back-end distribution agreements. I mean, wouldn't it be nice to have an RIA custodial platform where they actually have an incentive to offer the best solutions to us independent of what they're paying on the back end?

In fact, I think it's likely no coincidence at all that even though Vanguard's new platform won't launch until next month, until August, they chose this month, they chose this week, the week of July 4th to make the announcement, right? Because what better way to make an announcement about driving greater platform independence for investors than to announce it just in time for Independence Day? So, well done Vanguard, message received loud and clear.

This is Office Hours with Michael Kitces. Normally 1 p.m. East Coast time on Tuesdays, but we're a little late today due to meetings I had this morning. Thanks for joining us, everyone, and have a great day.

So what do you think? Is Vanguard's new NTF platform a bigger deal than has been reported in the media? Will their new NTF platform lead other ETF providers to offer lower cost ETFs that don't pay traditional fees to be on an NTF platform? Will this all ultimately lead to custodians charging advisors basis point fees for the services they provide instead? Please share your thoughts in the comments below!