October 3, 2019
What We’re Reading This Week
We did it! After a decade-long race to $0, Schwab has drawn first blood…sort of. I mean, like I said, this has been culminating over the past 10 years, so I guess it’s not really “first blood” but more of a “last blood” sort of thing. Now, everyone will have to follow suit.
In July of last year, Fidelity and Vanguard both took huge steps forward in the brokerage fee cold war, accelerating cost cutting so far that the only logical next step was to completely eliminate fees. Indeed, recent tech disrupters like Robinhood have already implemented fee-free platforms, they just lacked the scale to be truly competitive.
So now that the industry has completed its race to $0, what does this mean for investors? First, it should be clear, this is not a game changer. Brokerage fees at Schwab were $5 before last week’s announcement (and will be until October 7th). The people behind these cuts will talk a lot about eliminating barriers to the market:
“Most importantly, it’s the right thing to do for clients, removing one of the last remaining barriers to making investing accessible to everyone and continuing our tradition of challenging the status quo on behalf of individual investors.”
That is crazy– $5 is not a barrier to the market. If you only have $5 to your name, you shouldn’t be investing. Period. So, here’s the good, the bad, and the ugly:
Good: Hey, this one is really simple, right? If something used to cost $5 and now it costs $0, that is better. Certainly, for our clients, because we trade actively, no cost for trading is a win. Schwab may still charge something for more complex trades but ultimately, because of our trading volume, trading costs can be a barrier to entry for our more active accounts. This removes those barriers.
Bad: I would say that this negatively impacts retail clients (do it yourselfers) more than clients that work with brokerages through an advisor. Even though $5 should not really prevent people from investing, it does provide a small mental barrier to making sales of securities and, really, overtrading of all kinds. Most individual investors dramatically underperform the market/benchmarks as a whole, not because of fees but because of bad trades. They buy when they should sell. They sell when they should buy. However small the effect, brokerage fees were almost certainly dampening some trading activity, and now this is gone.
Ugly: How do I say this? Investment companies like to make money…and they are good at it. As much as they want to talk about “doing the right thing,” this just isn’t the case. This is a big problem for me. I think most people are okay with paying for a service. This industry, more than most, has a real issue with being transparent about costs. Trust me, someway, somehow, people are paying.
For example, Schwab will lose somewhere between $90-$100 million in revenue, but the company will make it back up elsewhere. Schwab, in particular, at least has a fairly clear revenue path. It makes its money on net interest margin through the bank that it owns. Trading fees were a very small percentage of annual revenue, whereas NIM (net interest margin) revenue accounts for roughly 57% of income. I think it’s problematic for retail investors in that Schwab doesn’t really explain this, but at least it isn’t a total mystery. TD Ameritrade on the other hand, does not own a bank. The company has some affiliate banking partners but still only receives 28% of its income from NIM.
One way firms like TD might augment their revenue is by payment for order flow. This is when a market making institution pays a brokerage firm to route its orders through them, typically in order to make another trade on the other side of the transaction. Specifically, if a stock is trading with a spread of $3 between the bid and ask, then a market maker would pay $1 to have a retail trade routed to them. It would then keep $2 and immediately sell the stock to someone else. In reality, these spreads are more like fractions of cents and the paying firm is executing trillions of these trades a day, but the fundamental issue is the same – in this world, brokerage firms are potentially incentivized to encourage people to carry a lot of cash and trade a lot.
Like most incentives, this is fine…if it is clear to the customer, and everyone plays by the rules. It’s worth noting, last year TD Ameritrade was accused of putting market makers ahead of its clients (https://www.wsj.com/articles/judge-oks-class-action-lawsuit-against-td-a…). This means instead of routing trades to give customers the best price, the company may have routed trades to the dealer that paid the most.
One final note of relevance; we live in an age where one of our most precious resources is our personal data. More and more companies are choosing to exploit our privacy. Someone once said, if you are not paying for it, you are not the customer. You are the product being sold. I don’t know if this will turn out to be prescient, but please keep in mind that brokerage firms will ask you for your income, total assets, social security number, and a host of other personal information. As always, it pays to do business with companies that will take your privacy seriously.