Investment houses don’t give away free money and they, like us, have bills to pay.

Retailers learned long ago that they can get you in the store with a ridiculously cheap product, but while you’re there, they’ll find lots of ways to sell you other more profitable — and possibly marked up — products. They’re not grocery stores, but recently Fidelity, Charles Schwab, TD Ameritrade and E*TRADE announced that henceforth, trades on their platforms will be free, hoping that’ll get you in their store.

Pershing, Vanguard, T. Rowe Price and other investment custodians that offer brokerage platforms have, as of this writing, not announced the same policy but there will be strong market pressure to do so. Because who doesn’t love a sale?

Nobody works for free or gives away something below cost without expecting future sales. No matter what low priced deals or dazzling investment returns they dangle in front of you, they’re always getting paid in some
way. So, all the press hoopla about “commission-free trades” and “no-cost mutual funds” is patently not true — investment houses don’t give away free money and they, like us, have bills to pay.

Secondly, you can depend on some journalists to know very little about the industry they cover, beginning with the meaning of some of the words they use. Investment houses rely on this, and nobody likes commissions anyway, so it’s a good slogan. Before you believe that something is free, know how you’re paying, because you certainly are.

Commission Free — 2 Meanings

Commissions, traditionally, are what you pay for mutual funds with a load. These include many funds that are sold to you by a traditional stock broker: fund families such as Lord Abbett, Putnam, Invesco, American Funds and many other recognizable names. A load is a commission, paid directly to the broker, for working with you.

This person may call themselves a financial adviser, but they are working on commission for what they sell you and it will be very unlikely that they’ll recommend a mutual fund that doesn’t earn them a commission. You can usually recognize funds that pay commissions because they will be termed A, B or C shares.

Charles Schwab, E*TRADE or any other investment house has no control over the commissions charged by an independent mutual fund.

If a fund is no-load — Vanguard, some Fidelity funds, T. Rowe Price — it’s commission-free on the front end (when you buy) and the back end (when you sell). It will be commission-free no matter where you purchase it.

Be careful, however, if the fund calls itself an adviser version because the adviser is often getting something. Don’t be afraid to ask and don’t stop asking until you understand the answer.

Exchange-Traded Funds (ETFs) Are Generally Commission Free and Always Have Been

Recent news reports have really muddied the issue, however. The headlines touting “commission free” are actually referring to trading costs. Trading costs are the charge the brokerage or investment house tacks on to each trade(buy or sell) to supposedly cover the business costs of the activity. Once upon a time, there was a specific trading cost for every “round lot” (block of 100 shares) you purchased, and more if you didn’t purchase round lots. Today’s trend is one charge for each trade — whether $35, or $9.95 or $4.95 or nothing.

How Will They Make Money? 
Reduced Service

Serving a retail customer is usually a low-margin business. The individual investor brings in relatively low profits for the brokerage houses and is usually very price conscious. People who pursue a buy-and-hold strategy, making relatively few trades per year, are not profitable. Roboadvisers have overcome this by providing essentially no service and no advice — you’re shunted into a computer algorithm and if you need anything more, you’ll generally be charged.

According to Devin Ryan, an analyst with JMP Securities (as quoted by CNBC online), TD Ameritrade, which has been popular with frequent traders, stands to lose about $900 million in revenue.

Since the TD merger with Charles Schwab was announced in November, analysts have speculated that there will be significant layoffs at TD. This is one way that costs, and obviously, attendant services, will fund the lost revenue. The individual investor will likely be on hold or speaking to an inexperienced person, or increasingly directed to online, preprogrammed activities and inform­ation. Since fewer human beings equals less cost.

Investing Cash Deposits

Besides reducing human contact, the large investment houses can make money on cash holdings by reinvesting at a higher rate than they pay. Most investment houses have a variety of cash accounts, but the now no-commission/trading cost places offer very low rates. For example, Schwab is currently offering rates of 0.06% to 0.30%, depending on which options you choose. If you want to write checks, pay bills and have daily access to your money, you’re probably going to be offered the investment options at the low end. Most places will count on the consumer being content with the default option because in a low rate environment people don’t have high expectations for cash anyway.

Different Rates Based on Size

Similarly, the less you have invested, the more you may pay. Some investments houses not yet on board with free-for-everyone will charge you a different trading cost depending on how much money you have invested with them.

Captive Audience

Another strategy pursued by Vanguard, and until recently, Schwab, is to make their own in-house mutual funds or ETFs free trade, but only if your account is housed with them. This stops you from driving around searching for the best bargains at any other investment house if you intend to select, say, Vanguard mutual funds.

Account Fees

If you have a smaller account, or accounts that require more extensive tax reporting, like SEPs (simplified employee pension individual retirement accounts), or you want paper statements, you may be charged an account fee. These are usually fairly low ($25-$100), but add up over many small investors.

Exploiting Arbitrage

This possibility is very hard for the individual investor to identify. Investment houses can sell customer trades to market makers and high volume, high frequency traders. These operatives can exploit a few fractions of a cent difference or a discrepancy in bid/ask prices (on ETFs), giving the individual poorer execution prices. You’ll never know.

Discouraging Personal Advisers and Fee-Only Advice

Financial advisers who provide personal advice on an individual basis can have a hard time finding a custodian to handle the trades for their clients’ accounts. Even though a fee-only adviser is paid by the client, the adviser must use a custodian to execute trades and hold investments. Some investment houses have even required advisers to have a minimum level of deposits. TD Ameritrade required $10 million of client assets within a year or so, or the adviser would be asked to leave. Others require even more: recently a Fidelity rep told me they’re only interested in advisers with at least $25 million in managed assets. Other custodians require an upfront payment, often of thousands of dollars. The adviser who encourages prudent, infrequent trading, or has a service model that also offers hourly planning, or focuses on issues besides gathering investment assets, will have more difficulty finding a custodian. Either those costs will be passed on to you, or personal, comprehensive planning will become even more difficult to find.

In addition, your adviser will be pelted with offers for a “special deal” on expensive software that will promote more frequent trading and more complex portfolios. It’s likely a sweetheart deal and the adviser who bites will pass those costs along to — guess who? But those reports sure are pretty. If you don’t want to trade frequently, or you want to rely on fiduciary advice instead of a robot, you’d better have several million dollars on account, with a significant cash stash, or you won’t be as interesting to the “free” investment houses.

An Example of ‘Free’

While I’ve just described some ways investment houses lure you to shop at their place, let’s look at just one example. Let’s say you keep two years’ worth of needed portfolio withdrawals in cash: $50,000 hypothetically. Let’s say you make 10 trades a year, more than I make for my clients, but maybe you’re buying individual stocks.

With the new “free” trades, you’re paying $0 for those 10 trades, and getting 0.15% on your cash deposits: $75. Now let’s consider another custodian, Pershing, through Share-holder Services Group, the one I use. There, those 10 trades are going to cost you $4.95 each, or $49.50. But the cash account pays 2%, so on your $50,000, you’ll collect $1,000. Which is the better deal?

Consumer Beware

Call me cynical, but I’ve rarely seen a brokerage house, corporation or employer roll out any change or deal that benefits you, the individual investor or employee, more than it benefits the company. If “free” is attached to the announcement, or it seems too good to be true, or it’s difficult for you to understand or calculate the benefits, you should be skeptical.

We do have to cope with the industry as it is at the present moment, but you should understand exactly how any changes will affect you. Also, give some thought to what it actually costs to stay in business — rates that have allegedly been reduced can also be raised after you become a customer, because they know you’ll be un­likely to change, or your investment house, like several roboadvisers, can simply go out of business. There’s a bottom line to the costs of keeping the lights on at the store.

This article was originally published in the January 2020 issue of BetterInvesting Magazine. Danielle L. Schultz, CFP, CDFA, is a fee-only financial adviser with Haven Financial Solutions, Inc.,based in Evanston, Illinois.

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