Dropping commissions draws focus to costs of investing

There was little fanfare on May 1, 1975, when fixed commissions were eliminated in the retail securities brokerage industry. That event, however, had a profound effect on business models and compensation practices in the decades that followed.

Once brokers were free to negotiate commissions, the marketplace became more competitive and diverse. New entrants included a multitude of discount brokers. Charles Schwab Corp. was a notable pioneer in the introduction of the "no advice" discount brokerage model. The emergence of the internet as a trading platform expanded the lower-cost options available to investors exponentially. And, as competitive pressures within the retail securities brokerage business increased, the appeal of recurring fee-based revenues became a significant factor in the evolution of the "advisory" accounts that are so popular today.

Charles Schwab emerged once again as a disruptive market force during the fourth quarter of last year when it announced that it would eliminate commissions on certain types of trades, including all stock and ETF purchase and sale transactions. Even though commissions were already low by historical standards, many other online discount brokerage firms soon transitioned to the "zero commission" model for certain trades. The result is that an investor who has an online brokerage account with one of these firms will pay no commissions on the designated transactions. Because investment returns are reduced by the payment of commissions, these developments are a big win for the investor who makes his or her own investment decisions and trades online.

While the elimination of commissions on certain types of trades is indeed a positive development for the online investor, savvy investors will consider how other possible costs could reduce investment returns in these accounts. For example, market volatility may necessitate the liquidation of an equity position for temporary defensive purposes. An important consideration for the investor in this scenario is how the proceeds derived from the sale of a portfolio holding will be invested. Customarily, sale proceeds were swept into a money market fund that was expected to produce a modest return. Today's investors cannot assume that a traditional sweep account will be an option. That's because some brokerage firms, especially those with affiliated banks, have eliminated traditional sweep accounts. These firms now require that the proceeds of portfolio transactions be placed in a bank account (i.e. with an affiliated bank) which will result in miniscule yields for the investor. This development is a win for the brokerage firm and its affiliated bank, but not the investor. It is also worth noting that the so-called "free trades" are limited in scope, and do not apply across the board. For example, fixed income investments, like bonds, trade at undisclosed mark-ups in a rather opaque market. These new "zero commission" accounts offer few, if any, advantages for the investor who will structure a portfolio consisting primarily of fixed income investments.

Investors may wonder how brokerage firms can afford to eliminate commissions on stock and ETF trades. Although business models differ throughout the industry, most brokerage firms do not derive revenues solely from commissions on portfolio transactions. One potentially lucrative source of income involves order routing strategies. A common industry practice called "payment for order flow" enables the broker initiating a trade to receive compensation from the broker chosen to execute the trade. The executing broker makes money on the spread between the bid and ask prices, i.e. the price at which a particular stock can be bought and the price at which it can be sold. Because spreads are generally small, volume is a critical component in the "payment for order flow" scenario. An executing broker that receives a large volume of transactions from another firm is willing to give a cut of its profits to that firm. The conflicts of interest posed by these arrangements have been a regulatory focus.

While there has been a great deal of industry buzz about the "zero commission" opportunities available to investors today, many investors prefer to maintain accounts with full-service firms where they can benefit from a relationship with a financial services professional. An investor working with a financial professional at a firm that is registered both as a broker-dealer and an investment adviser may have both brokerage accounts and advisory accounts, and not even realize that. The distinction between a brokerage account and an advisory account is one with many differences that are not well understood by investors. Account type matters. We consider some scenarios.


Brokerage accounts

An investor who has a brokerage account with a full-service brokerage firm and relies on the recommendations made by his or her broker will pay transaction costs in accordance with the schedule established by the firm. Investors having this type of account will want to inquire about commission schedules and read their account statements carefully. It is simply too soon to determine whether the race to zero commissions will result in adjustments to the commission schedules of full-service national and regional brokerage firms.

In addition to the securities that may be purchased in the online trading accounts discussed above, full-service national and regional brokerage firms may offer equity investments that involve securities issued in reliance on exemptions from the registration requirements of the Securities Act of 1933. These high-risk, high commission products continue to be popular, and, according to Investment News, we can expect these products to proliferate. Commissions, which are limited by the Financial Industry Regulatory Authority, can be upwards of 10 percent.


Advisory accounts

An investor who has an advisory account with a firm registered as an investment adviser will pay an advisory fee for management of the account, and may or may not pay commissions on transactions made in the account. These investors will want to refer to their adviser's Brochure (Form ADV, Part 2A) for details relating to the costs that they will incur in connection with the management of their accounts. A "wrap-fee" account is a type of advisory account in which clients pay a specified fee for both investment advisory services and execution of portfolio transactions.

The new "zero commission" model may have implications for advisory firms, especially in situations where assets of clients are custodied at brokerage firms that provide both trade execution and custody services. Registered investment advisers are fiduciaries and, as such, operate within a regulatory framework which requires that they seek "best execution" in connection with portfolio transactions for clients. The term "best execution," however, is not easily defined. Transaction costs are a consideration, but not the only consideration. In view of recent developments, it is likely that advisory firms will re-evaluate their obligations with respect to the execution of portfolio transactions.


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. This column is a collaborative work by Patricia Foster and David Pear­tree. David Peartree is a registered investment adviser offering fee-only investment and financial planning advice. The information in this column is provided for educational purposes and does not constitute legal or investment advice.

Published: Wed, Feb 19, 2020