Last year, Charles Schwab announced that they were reducing trading fees to zero, and Ameritrade, E*TRADE and Fidelity shortly followed. Hooray, free trades! But hold on are there hidden costs in no cost trading?
For consumers of these companies, however, there really is no free lunch. It is important to look to see what you are actually paying for, good or bad. It may be that you are in something that has very transparent fees that are reasonable and worth it. Or…. there might be a catch.
How do investment firms that offer trading services make money?
• Using their customer’s cash like a bank:
Some firms make money by leveraging their customers’ cash. They pay their account holders a small rate of interest on their cash balances, and then they use the cash to lend out to other customers at a much higher rate. The difference is their profit.
Watch out for:
Firms that put a lot of your money in cash. One of the computerized investment services (robo-advisors) may invest up to 30% of your account in cash. Do you know what interest rate you are receiving on cash? It is most likely not as high as what you could get if you invested your money in something else like a money market. Keep in mind that a money market fund is not covered by FDIC insurance.
• Getting paid by the other side of the trade
If you sell something, someone else must buy it, and vice versa. Let’s say you place an order to buy Apple stock. Instead of the order being processed on a public stock exchange, some brokerage firms route your order to any number of electronic traders that are “market makers.” Essentially, they shop the trade around to other big players in the market. These market makers are trading securities for their own account and are trying to take advantage of the difference between the stated buy price and sell price. Firms are required to disclose if they are a market maker in the security you are trading, but sometimes it is not exactly highlighted in bold print, and many consumers do not understand.
Watch out for:
Typically, the view is that market makers are good because they provide the liquidity that the market needs, and if there are several, then the competition ensures the best execution of trades. However, as brokerages decrease the amount of fees that customers are paying via trades, they still must cover their costs, and so the difference between the buy and sell prices might increase. If you are a trader, you will want to pay close attention to the spreads.
Expense ratios of the security themselves
Let’s not forget that these commission free trades are mainly for stocks and exchange-traded funds (ETFs) which are low-cost investments. There are still many mutual funds with high sales commissions and expense ratios.
Watch out for:
If you are paying for active management, you will want to make sure that the manager meets the goals that you have discussed with them. Or if you pick an actively managed mutual fund, you will want to compare performance to index benchmarks to see how they fare. The lowest cost investment does not mean the best performing investment.
Commission Charges
These are being phased out and have already gone away at large low-cost brokers like Schwab. That does not mean that everyone is charging zero, however.
Watch out for:
At some of the larger brokerage houses, they still have a steep commission scale. And depending on what type of mutual fund you buy; you may still be paying a commission.
The real hidden costs of zero commissions lies within investor behavior. And let’s face it, the average investor is not doing themselves any favors going it alone. Rarely, do people just buy and hold. What usually happens, is that there are emotions at play and investors panic and buy and sell at the worst
possible times. If you were invested in the S&P 500 the entirety from 1999-2019, you would have earned a 6.1% return. The average investor earned a 2.5% return during the same timeframe.1
I recently spoke to someone who said that they “lost everything” in the financial crash of 2008-2009. But this would only happen if they sold the investments that they had at that time. The stock markets did not go to zero. In fact, if you were 100% invested in the S&P 500 index stocks during 2008-2009, you would have seen a 401%+ return from then until February 19, 2020. 2
Because of the tendency for investors to panic and sabotage themselves, having zero trading costs could encourage people to trade more often, which rarely leads to great returns. 3 There really is no free lunch, and I encourage you to peek under the hood at your own investment costs and returns.
Disclosures
*Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Stephens Consulting, LLC, doing business as Stephens Wealth Management Group (SWMG), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.
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1 Source: J.P. Morgan Asset Management; Dalbar Inc. Average asset allocation investor return is based on an analysis by Dalbar Inc., which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Returns are annualized (and total return w here applicable) and represent the 20-year period ending 12/31/19 to match Dalbar’s most recent analysis. Guide to the Markets – U.S. Data are as of December 31, 2019.
2 Source: Compustat, FactSet, Federal Reserve, Standard & Poor’s, J.P. Morgan Asset Management.
Dividend yield is calculated as consensus estimates of dividends for the next 12 months, divided by most recent price, as provided by Compustat. Forward price-to-earnings ratio is a bottom-up calculation based on the most recent S&P 500 Index price, divided by consensus estimates for earnings in the next 12 months (NTM),and is provided by FactSet Market Aggregates. Returns are cumulative and based on S&P 500 Index price movement only, and do not include the reinvestment of dividends. Past performance is not indicative of future returns.
Guide to the Markets – U.S. Data are as of December 31, 2020.
3 Source: https://www.aaii.com/journal/article/trading-more-frequently-leads-to-worse-returns