David Peartree, BridgeTower Media Newswires
There’s an internet meme that says, “when something online is free, you’re not the customer, you’re the product.” Well, online trading just became free at several of the largest brokerages. The question for investors is, are you the customer or are you the product?
The list of things that are truly free is distressingly short. There is the air we breathe, but what else? Even “free” water from the tap has a cost. You have a water bill, right? Facebook and Google Maps can be used without any direct out-of-pocket cost, but once you sign up your data is theirs. You become the product, no longer the customer. We should know by now that few things are ever really free. There’s nearly always a catch.
The brokerage business is now in the midst of a race to zero cost trading. On its face, this appears to be a boon for small investors. But is there a catch? In October, Charles Schwab Corp., one of the largest full-service brokerage firms, announced that it would no longer charge to buy or sell stocks or exchange traded funds. ETFs trade like stocks in that they can be bought and sold on an exchange throughout the day. Several other firms, including TD Ameritrade and Fidelity, quickly followed Schwab’s move and others are expected to follow.
Historically, trade commissions were a major source of revenue for brokerage firms, but the long term trend has been down. In the 1970s, Schwab charged about $70 per stock trade. In the 1990s, commissions were about $30 per trade. Over the past 10 years we have seen commissions fall at most brokerages from around $19.95 per trade, then to $9.95, again to $4.95, and now to zero. Five years ago, trade commissions represented about 14 percent of Schwab’s total net revenue. As of 2019, commissions are only about 7 percent of Schwab’s net revenue. Other brokerages may derive higher revenues from trading than does Schwab, but the trendline industrywide is the same. Now, Schwab, an industry leader, has taken trading costs to zero. Why, and what does it mean for investors?
In some ways, this latest news is a logical extension of the long-term trend of decreasing investments costs overall. Schwab has long been an innovator in reducing investment costs. The company first established itself as a discount brokerage firm after commissions were de-regulated in the mid-1970s. Over time, Schwab grew to be one of the largest custodians used by registered investment advisory firms to house their client’s funds. It is also a popular custodian for “do-it-yourself” investors. Schwab now holds approximately $3.8 trillion in investor’s funds.
As the cost of trading has trended down, brokerages like Schwab have looked for other ways to make money. One approach has been to offer investors a select list of ETFs available to trade commission-free. Instead of earning money directly from the trades placed, custodians could charge the ETF providers a fee to allow their funds to participate in these select lists of funds available for online trading at no cost. ETF providers might pay some combination of an upfront fee and an ongoing fee, the latter often structured as a percentage of the average daily balance held in those funds. The practice is not unlike that of food companies who pay for preferred shelf space at the grocery store.
With the announcement that all ETFs would trade commission-free, Schwab and the other brokerage firms that follow suit are walking away not only from any revenue from trade commissions, but also from the revenue they received from ETF providers for the privilege of being listed on the commission-free platform. Why would they do that?
The answer is cash. Schwab, like other brokerage firms, has changed the options investors have for managing cash in their accounts. In the past, cash deposits were automatically swept into a money market fund paying higher rates than the typical bank deposit. Now, at most brokerage firms, the automatic sweep feature has been removed and investors must take affirmative steps to move their cash deposits into money market funds or other options paying a higher rate.
Schwab’s business model, and that of some of the other brokerages, looks more and more like that of a bank than of a conventional brokerage firm. Cash deposits in a Schwab account are held with Schwab Bank, an affiliated entity. More than 60 percent of Schwab’s revenues come from net interest revenue, far outstripping what it earns from trades. Net interest income consists in large part of earnings on cash deposits. Like a bank, Schwab pays lower rates on investors’ cash deposits and keeps for itself the higher return it earns from investing those deposits. Other brokerage firms have similar bank affiliations. TD Ameritrade has TD Bank; Merrill Lynch has Bank of America.
Like the grocery business, the brokerage business operates on relatively low margins and profitability requires economies of scale. Staying profitable in the new “commission-free” marketplace will require that firms grow by acquiring more accounts and cash from which they can produce interest revenue. Scaling up in size will come, at least in part, from consolidation among brokerage firms. In fact, shortly after the announcement of the move to commission-free trading, Charles Schwab also announced plans to acquire TD Ameritrade. We can reasonably expect even more industry consolidation.
ETF providers will also be incentivized to innovate more with their fund offerings as they will no longer have to pay to be listed on a brokerage firm’s list of preferred funds.
Commission-free trading means that ETF providers no longer have to worry about certain funds being overlooked by investors simply because of trading cost. Said one ETF provider about the move to commission-free trades, “the continued evolution of the marketplace will allow investors equal access to innovative products including alternative investment strategies that provide investors with unique hedging benefits.” Whether investors will benefit, as opposed to being harmed, by such innovation is another matter. In any case, expect a further proliferation of “innovative” ETF funds.
The move to commission-free trades has the potential to be a net positive for investors, but investors should always be cautious when the large financial firms find new opportunities to make more money from them. The following considerations should be kept in mind.
Manage your cash lest you become the product and not the customer. Some amount of cash in an account is unavoidable as you manage inflows and outflows. Just remember that brokerage firms make more money if you let large amounts of cash sit idle in its bank deposits. Avoid keeping excess amounts of idle cash when better opportunities can be found in CDs, Treasuries, and even short-term high quality bond funds, all of which should be accessible from the typical brokerage account.
Don’t over-trade. Just because trading is free doesn’t mean it’s smart. Investors with strategic, long-term allocation plans shouldn’t be trading often anyway. For such an investor, free trades are of minimal significance.
Use ETFs carefully. ETFs are excellent investment vehicles, but they come with additional complexity. The pricing of ETFs is more complex than it is with mutual funds: investors need to deal with the bid/ask spread and with premiums/discounts. Trading is also more complicated, and investors should know when and how to use different types of trade orders. These are not insurmountable problems (and they are beyond the scope of this discussion) but investors who ignore these issues are assuming risks for which they may be unprepared. For some investors, conventional mutual funds may be a better option, never mind the trading cost.
When asked on a conference call what the move to commission-free trading meant for the competitive landscape, the CEO of Blackrock, a market leader among ETF providers, said, “If you could see my face, I’m smiling at the opportunities.” Investors beware.
—————
David Peartree is a registered investment advisor offering fee-only investment and financial planning advice. This column is a collaborative work by David Peartree and Patricia Foster. Patricia Foster is a securities law attorney whose experience includes representation of clients in various sectors of the financial services industry, including, broker-dealers, investment advisers, and investment companies. The information in this article is provided for educational purposes and does not constitute legal or investment advice.
