Prior to 1975, if you wanted to trade in US stocks you had to pay a fixed commission. Then the SEC abolished fixed commissions and discount brokers like Charles Schwab began offering lower prices for trading. 2019 will go down as the year that trading commission costs virtually disappeared completely. Robinhood had started offering free stock trading and accumulated millions of clients, and on October 1, 2019, Charles Schwab announced that it would offer free stock trading. TD Ameritrade and ETrade responded by matching Schwab’s move, and then Fidelity joined the party a week later. At the start of 2020, Vanguard, annouced they would also offer no commission trading.
Before I got the email that Vanguard was eliminating commissions, I was hoping that Vanguard would announce that their trading commissions would be reduced to a minimal amount that would reflect their actual costs. I've seen reports that online trading costs the discount brokerage firms just pennies. Obviously, there are some costs for the overhead, technology, and related costs. So personally, I would rather see a transparent and honest firm charging the actual cost. But, if it is pennies, it makes sense both practically and psychologically to offer it for free. Its comparable to a restaurant charging a few cents for tap water when requested. Its not actually free since most do pay for water and then you have the costs of the glass, cleaning, and staff. But if you are already ordering something at the restaurant, it makes sense to include it for free.
Commissions are not the only cost that's coming down for investors. But like with commissions, which took decades to go to virtually zero (thanks in large part to technology and economies of scale), other investment costs are also trending lower. Ultimately, it is investors that need to force those price changes. For instance, Vanguard has a history of steadily lowering costs on their mutual funds and ETFs. In fact on December 26, 2019 Vanguard cut fees on 56 of its funds, from already low to even lower costs. That was not surprising because Vanguard is a mutually owned firm and does not seek to maximize profits, unlike most other investment firms. What was somewhat surprising was the news, also in late December, that Dimensional Fund Advisors was also cutting fees. Dimensional is one of the largest factor based investment firms and it has succeeded in part by leveraging the research of academics like Eugene Fama, the originator of the efficient market hypothesis. They try to minimize portfolio turnover and trading costs while investing passively, based on so-called risk factors, or market anomalies, like value and market capitalization. But DFA has been competing with other factor based investing options, many of which feature ETFs, while DFA has historically focused on mutual funds. DFA funds are generally marketing through investment advisors and the cost cutting appears to be a competitive move to discourage those advisors from investing their client's money in alternatives including many of the factor based and index based ETFs.
Another recent news item was the announcement that RobinHood, had been fined by FINRA for claims that it did not ensure best execution. One potential problem with firms offering free trading is they have to make money another way, and some of those firms direct trades to organizations that pay for order flow. If trades are directed to a venue that is not providing the best price available in the market at that moment, that's a problem.
That's where icebergs can help investors understand that commissions, which are now smaller than ever, are only one of the components of investment costs. Wayne Wagner, my former boss at Plexus Group started using icebergs to help explain transactions costs to the firm's clients, which were mostly large money managers, many of which transacted in such large amounts that they pushed prices significantly when they traded aggressively. The commissions and impact costs are visible (above the surface), but delay and opportunity costs are harder to calculate (and are below the surface) and they often exceeded the visible costs.
For individual investors, its not the impact and opportunity costs that tend to be the problem. The major costs often come from management, advisory, platform, and other fees that often outweigh the trading costs (as well as the bid/ask spread). Taxes can also be significant for investors trading in taxable accounts. Spreads, and other fees (as well as taxes for some) can be significant even with no commission trading.
Others in the industry have picked up on the iceberg comparison. For instance, Personal Capital's Hidden Beneath The Surface: What Americans Are Paying in Advisory Fees report sports a iceberg image on the cover. They used various forms of data to suggest that Ameriprise Managed Accounts & Financial Planning program costs could easily exceed 3% per year. They also listed UBS, Morgan Stanley, Wells Fargo, Merrill Lynch and others for having potentially high investment costs.
Jason Wenk at Altruist also uses an iceberg in comparing commissions to total investing costs. Miniscule commissions are a great benefit to investors, but they can make it easy to lose sight of the fact that commissions are not the only cost of buying and selling securities. Brokers, specialists, and market makers participate in the markets only when they expect to make profits. Those profits are the price that investors and other traders pay in order to execute their orders when they make trades. The bottom line is that its great that commissions are minimal, but they are historically a very small component of the total costs for many investors. Smart investors should try to minimize all their investment costs, so they can maximize their returns.
Those interested in much more information about investment costs can see Chapter 7 - Investment Costs, Trading Costs, The Bid/Ask Spread in The Peaceful Investor - Paperback at Amazon or Kindle (only $7).
Gary Karz, CFA
Author of The Peaceful Investor and Publisher of InvestorHome.com
twitter.com/GKarz (email)
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