Equity Trades are Free – But there is no Free Lunch

Broker price wars

Before 1975, brokers had it really good. Commissions were fixed and regulated-at very high levels. It would sometimes cost hundreds of dollars to buy 500 shares of a blue-chip stock. That changed in 1975 when the SEC opened commissions to market competition.   A young Chuck Schwab and others became discount brokers- often charging ½ or less of the old rates. Since then, fees have continued to fall and earlier this year, trades could be made for $5 or less. Now, Charles Schwab & Co. as well as TD Ameritrade, E*TRADE and others have cut stock and ETF trades to zero. Free trading of equities has arrived.   Please be advised, though, that there is no free lunch- brokers profit from you even if they don’t charge for equity trades.

Here are some the main sources of income for brokerage firms:

  • Trade commissions
  • Brokerage fee- to hold the account
  • Mutual fund transaction fee-charges when you buy or sell a fund
  • Operating Expense Ratio-an annual fee charged by mutual funds, index funds and exchange-traded funds (“ETFs”)
  • Sales load- A sales charge or commission on some mutual funds paid to the broker or salesperson who sold the fund
  • Uninvested cash- brokers become bankers and lend it out

Let’s focus first on uninvested cash. In 2018, 57% of Schwab’s income came from loaning out its customers’ cash. As is typical in the brokerage business, uninvested cash is swept to an interest bearing account. However, sweep accounts typically earn almost nothing- usually ½ to ¼ of 1% or lower to the investor.

Schwab had a total of $3.7 trillion of deposits, with about 7% of it ($265 billion) in cash earning nice returns for them. Assuming a return of 2.5 % on the uninvested cash, that’s a return of $6.6 billion. The cost of that money was likely ½% or about $1 billion, with Schwab netting about 2%. $5.7 billion of Schwab’s $10 billion net revenue in 2018 was earned on its customers’ cash. Virtually all the brokers use the same model with uninvested cash.

Robo- advisors generally use the same format. Virtually all of them charge lower fees but require a certain amount of cash, between 4% and 30% in their pre-set asset allocations. Yes, there is a small sweep account interest paid on those funds, but not much. And, this is all typically disclosed. The rate paid on clients’ cash “may be higher or lower than on comparable deposit accounts at other banks” is a typical warning.

The use of uninvested cash is income for the brokers and reduction in performance for the investors. Let’s say your portfolio has 10% cash generating a 0% return. If your annual return on the invested 90% in your portfolio is 6%, then the return on 100% of the account is only 5.4%. A huge difference over time. As an example, the difference between earning 5% per year versus 6% a year on $100,000 for 30 years is $142,000.

Now, let’s look at the operating expense ratio (OER). OERs are charged by mutual funds, index funds and ETFs. If a fund has an expense ratio of 1%, that means you pay $1 annually for each $100 invested. If your portfolio was up 6% for the year, but you paid 1% in operating expenses, your return is actually only 5%. The OER is designed to cover operating costs including management and administration.

The first mutual funds were actively traded, meaning that the portfolio manager tried to beat the market by picking and choosing investments. Operating expenses for actively managed funds include research, marketing and significant administration with OERs often at 1% or more. Index funds are considered passive. The manager of an index fund tries to mimic the return of a given benchmark, e.g. the S&P 500 Index. Index funds should have significantly lower operating expense ratios. Evidence shows that actively managed funds, as a whole, don’t beat the indices. In fact, as a group, they underperform by the amount of their OER.

Operating expense ratios, primarily because of increased use of index funds and ETFs to minimize costs, have been getting smaller and smaller. In fact, we have seen some funds at a zero operating expense ratio. However, for these funds, a substantial amount (10% to 20%) of cash is maintained in the fund.

Conclusion: Set a target of 1-2% cash in your portfolio. Stay invested for the long term.   In addition, the investments in your portfolio should have very low OERs, wherever possible. However, in selecting investments, you need to look at both the OERs and the typical cash position of the mutual fund, index or ETF. Even if the OER is zero and the security holds 10% in cash, your performance on that holding will likely only be 90% of the benchmark, at best. Remember, when equity trades are free, brokers will continue to look for ways to make money, often at your expense.

What is NAPFA?

NAPFAElise recently helped me change the artwork in the office. Added some, moved some, and removed a couple. The best addition was a map of Sanibel Island signed by our kids and grandkids, and now, thanks to Elise’s help, it includes pics of everyone. Sanibel has always been a special vacation place for our family. Great memories.

Another nice addition was my NAPFA acceptance letter, related Fiduciary Oath signed by me, and the recent Accredited Investment Fiduciary (AIF®) certification I received. Brett has these three items in his office as well. We’re often asked by clients and others for more information on NAPFA and AIF® so we thought it might be worth an explanation.

NAPFA (pronounced ‘Nap-Fah’) stands for the National Association of Personal Financial Advisors. NAPFA and its members are all about bringing integrity, honor, and trust to its clients and to investors in general. Its members are strictly fee-only, independent, Registered Investment Advisors just like DWM. NAPFA vets its candidates very carefully, including credentials, experience, peer review of a sample comprehensive financial plan, and signature and adherence to NAPFA’s Fiduciary Oath.

The AIF® designation is awarded by the Center for Fiduciary Studies, the standards-setting body for fi360, the first full-time training and research facility for fiduciaries in the country. AIF® is a very select group. There are only 6,000 AIF® designees currently, as compared to 70,000 CFP® certificants. AIF® designees are the only recognized professionals trained to perform fiduciary assessments, which measure how well investment professionals are fulfilling the fiduciary duties required of them by the applicable investment legislation, case law, and regulatory opinion letters. AIF® designees, like Brett and myself, are able to use the knowledge and resources they have gained through their training to better organize, formalize, implement and monitor their processes and procedures. Studies show that a prudent process improves investment results.

There is a tremendous investor movement away from large brokerage firms to smaller, fee-only independent firms such as DWM. In my opinion there are two key reasons for this: results and trust.

According to the WSJ, “Investors are Fleeing Active Stock Managers.” Actively managed stock and bond mutual funds are the building blocks used by many large institutional wirehouses. The operating expense of an actively managed mutual fund is generally a minimum of 1% more per year than a passive, low cost mutual fund or ETF. Actively managed funds have a lot of expenses a passive fund doesn’t have. These can include research (to try to beat the market), trading, marketing, upfront fees, sales fees and others. Of course, the institutions that promote these actively managed funds to investors receive part of those operating expenses as “revenue sharing.” The investor comes out the loser in this format, since studies have shown time and time again that actively managed stock and bond funds over time don’t “beat the market”, but rather they consistently underperform the benchmark indices. And, that underperformance is usually by about 1% or more, just about the same amount as the “excess fees” over passive investments. The extra 1% in expenses goes right to the bottom line, especially these days when diversified stock returns are more likely in single digits than double digits. A 1% drag on a $1 million portfolio would reduce the appreciation over 20 years by $600,000 or more. It’s no surprise that many large institutions don’t even provide performance results with their statements. The reports can be 100 pages long and yet there is no performance data provided (i.e. time-weighted return calculations). The WSJ article puts it this way, “U.S. active managers destroyed the trust of individual investors and financial advisers, neither of whom want to pay up for active management that can’t beat an index.”

So, many large brokerage institutions have tried to gain the public’s trust (and their money) by advertising themselves as fee-only and fiduciaries. While there may be a small portion of their offering that does qualify to use these terms, their overall business model is generally focused on making money for the institution and its employees. They may charge a client a percentage of asset fees for managing money. That’s not all they get. They often receive “revenue sharing” from mutual fund companies they promote to clients and receive commissions for selling annuities and life insurance contracts.

Have you seen the recent Charles Schwab “Why” TV Commercial? The ad revolves around a boy who quizzes his father about the real value the family’s financial advisor provides. It suggests that most children can see that the wirehouse business is stacked in favor of the advisor, not the client. These days, both children and their parents are really questioning what they are getting and paying these brokers. True fiduciaries put their clients’ interests first and disclose any potential conflict of interest. They hold themselves accountable for results and make full disclosure to their clients. And, they provide additional value-added services and transparency. The general public, I believe, is recognizing that the wirehouses just don’t do that.

NAPFA and its members are gaining a lot of traction. Investors looking to move from the old wirehouse paradigm can contact NAPFA and use its website www.NAPFA.org, to find vetted financial advisers in their area who might be a good fit for them. DWM gets communication, prospects, and ultimately clients from our association with and link to NAPFA. No money changes hands between us. Like DWM, NAPFA is all about doing the right thing; bringing integrity, honor and trust to its clients and investors in general. That’s why we are proud to be members of NAPFA® and AIF® designees.