No-fee ETFs could squeeze online investing platforms

Social Finance, the online lender specializing in student loan refinancing, has taken the first step toward offering zero-fee ETFs and becomes the latest financial services firm to wade into the domain of traditional wealth management.

SoFi is helping start two new passive funds and plans to waive charges for at least the first year, according to SEC filings reviewed by Bloomberg. The San Francisco-based firm already offers personal loans, mortgage loans and term life insurance, among other services.

The latest products compete directly with independent robo advisors like Betterment and Wealthfront that have traditionally offered low-cost passive investing, as well as newer automated platforms offered by incumbents like Merrill Edge.

While the “race to zero” may not come as a shock to many investors, the entrance of an online lender took some in the industry by surprise.

Fidelity, JPMorgan and Vanguard were quick to respond to similar success from Robinhood and its no-fee trades, says Forrester senior analyst Vijay Raghavan. Now, large financial firms may be looking to cash in on the success of automated investing platforms.

“The marketing gimmick of permanently lower pricing is quickly becoming the industry standard and is here to stay,” says Raghavan.

ETFs charge an average of $4.70 per $1,000 invested, but some that track broad U.S. equity indexes now charge as little as 30 or 40 cents. Funds from BlackRock, State Street and Charles Schwab account for about 60% of the $3.7 trillion market in U.S. ETFs, according to Bloomberg. In fact, more than 97% of cash flowing to ETFs going to those that charge $2 or less for every $1,000 invested (or 20 basis points), according to Bloomberg.

By offering free investment products, SoFi is looking to gain significant traction in the ETF market and will likely look to cross-sell other products and services to its customer base.

“In the industry, there is generally poor integration between banking and investment functions,” says Will Trout, head of wealth management at Celent. The exception is Bank of America and Merrill Lynch, he says, which integrated banking functions with its automated investment platform Merrill Edge.

“That space is heating up,” Trout says.

Traditionally, banks have been in the business of building up deposits and using the interest earned from those cash floats to fund their loan books, says Trout, meaning that banks may not want to share a lucrative part of their business model with other firms. But, that may be changing.

Wealthfront recently announced a partnership with two banks to offer clients a cash account with competitive interest rates of up to 2.24% and is FDIC insured up to $1 million, according to a spokeswoman. Instead of using a traditional bank account, clients can use the Wealthfront accounts as a fully-insured place to keep their cash. The average Wealthfront account has around $41,000, according to public filings.

“Historically, deposits have been really profitable,” Trout says. “Robos will have to figure out a way to make a partnership work for the bank partner.”

The move comes two months after Robinhood’s high-profile foray into the banking sector. The no-fee stock trading app initially rolled out a similar cash account comparable to traditional bank accounts — but with a relatively high 3% interest rate. However, the firm had not communicated with the SEC before soliciting the product. After public backlash, Robinhood quickly scrubbed the page from its website.

Other firms have offered no-fee investment products, but the SoFi offering will be the first foray in free passive vehicles.

To be sure, there are some potential challenges. For one, the no-fee investment products may encourage more active investing by inexperienced investors leading to imbalanced portfolios, Raghavan says.

“The allure of free investing sounds nice until investors realize they are in over their heads,” Raghavan says. Instead of trying to entangle customers with additional financial products, firms should earn customer loyalty by developing better advice to help inexperienced investors understand the nuances, he says.

The appeal of learning to trade stocks without the worry of commissions eating into returns may encourage active trading and unintended consequences for some investors, Raghavan says.

“In a volatile market, or a stock market crash, a lack of diversification will lead to greater losses — making young investors less likely to invest through the next economic cycle.”