Last week, Charles Schwab & Co., Inc. announced they were reducing the cost of online equity trades to zero starting October 7. Yes, you read that correctly – there is no commission charged to buy and sell stocks or exchange-traded funds (ETFs) when trades are placed online. Competitors TD Ameritrade and ETrade quickly matched Schwab’s move.
Trading costs have been falling for some time, reaching $4.95 for most trades starting last year. The explicit costs of buying and selling stocks for strategic, long-term investors has not been a substantial portfolio expense for years. So, what does it mean that transaction costs are now zero, and is anything really free?
The truth is, commissions and other explicit charges were not that significant for most firms, amounting to just 7% of Schwab’s total revenues in 2018. Brokerage firms make money in a number of ways, most of which are not visible to the average investor. A good percentage of profits at brokerages comes from the client’s uninvested cash, such as dividends from stocks or interest from bonds that are swept into accounts. As of June 30, deposits at Schwab’s bank that holds uninvested cash totaled over $200 billion.
This past week, clients were earning between 0.12% and 0.50% on these cash balances at a time when short-term market rates are in the 1.50% to 2.0% range. Schwab isn’t alone in this strategy. Across the brokerage industry, most sweep accounts pay measly rates, often as low as 0.05%, allowing firms to make money on the spread between what they earn on that cash and what they pay investors.
Brokers also make money on order flow, which is a little more complicated. In the financial markets, payment for order flow refers to the compensation a broker receives to influence how client orders are routed. Market makers such as institutional dealers and some securities exchanges are willing to pay brokers for the right to transact with the broker’s clients. The firms who pay for order flow hope to profit from the bid/ask spreads, capturing a penny or two on millions of daily trades. The practice has long been controversial, but not illegal. Brokers like it because they make money under the table – their preferred method, it seems.
In our role as independent advisors and fiduciaries for clients, our job is to make sure our clients are being treated fairly. We don’t mind the brokerage firms making a profit. After all, they do provide valuable custody services and invest in technology for trading, cyber security, and other amenities that make our clients’ lives easier.
What we object to is paying more than necessary. We take several steps to combat brokerage firms’ tendency to hide the true cost of doing business. We work to limit the amount and time that uninvested funds stay in brokerage bank accounts. Some cash is necessary for planned distributions or other short-term needs. When cash is needed for more than a few days, we use a more proactive “enhanced cash” strategy to capture market-based returns.
We closely monitor not just explicit costs but implicit trading costs. Every quarter, we review trading statistics at Charles Schwab, our primary broker, and compare their trade execution numbers to other firms. We currently maintain trading arrangements with eight other brokerage firms and do not hesitate to trade outside of Schwab when it benefits our clients.
At the end of the day, nothing is free. In the financial marketplace, the fees you see are often less than the “fees you don’t see.” While we appreciate the recent commission cuts by brokers, we also continue to monitor them closely.
Contact us at 865-584-1850 or info@proffittgoodson.com