The cost of zero commission trading
Major custodians such as Fidelity and Charles Schwab have recently dropped individual stock and ETF (Exchange Traded Fund) trading fees to zero. How will this impact investors and the future of investing? Here’s our view.
The invisible costs
No fees to buy or sell a stock or ETF sounds almost too good to be true.
On the one hand, a zero-commission environment allows investors to make the most of all their cash. If you have a small cash balance, let’s say one or two hundred dollars, it may not be worth it to make a trade and put the money to work when a trading fee is involved. The marginal gain reaped from a small position wouldn’t necessarily outweigh the ticket fee (previously about $5 to $15 per trade). With zero commissions, it becomes potentially more efficient to do that.
Let’s look at what happens after a trade is “born.”
Once a trade is entered into an order management system with a broker such as Fidelity, Charles Schwab, TD Ameritrade, etc., it is routed to various intermediaries and exchanges for potential price improvement relative to the nationwide quoted prices for a particular security.
The Marketplace Cost
Why “prices” instead of “price”? Because the price you pay depends on whether you are acquiring or divesting the stock or ETF. If you are acquiring, you’ll pay the ask price – the lowest price the other party is willing to sell. If you are divesting, you’ll pay the bid price – which is the highest price at which the other party is willing to buy.
For example, Apple (AAPL) had a bid of $237.19 and an ask of $237.26 recently. If you want to acquire Apple stock, you’ll pay $237.26. The difference between prices, “bid-ask spread”, is basically compensation that goes to the intermediary that matches the buyers and sellers. The bid-ask spread also appears when trading ETFs.
Other Factors
Certain factors may come into play and impact the final execution price, things such as the liquidity of the stock, order size, the demand for the stock, availability of market makers, and the volatility on that particular trading day. All these factors make the bid-ask spread narrow or broad and in turn affect the price at which the trade ends up being executed.
The bottom line is that whether you are paying an outright fee or not, trading still costs money.
Still Some Direct Costs
Keep in mind that not all trades will be free; while this change will dramatically reduce trading costs, by no means will they be obliterated across the board. Commissions will persist in some cases. Some options may still carry trading fees. Mutual funds with sales loads, which are mandated by the fund’s prospectus, will still carry a direct cost to the buyer. Finally, we expect that custodians will continue to pass along a nominal fee that the SEC assesses (also known as the Section 31 transaction fee) on certain trades.
Industry impact
While the zero-commission environment seems like a win for investors, there are implications for the industry as well.
It is hard to determine the long-term impact, as some of the major players vary in type and structure. Some are publicly traded stock companies like Charles Schwab, while others are private companies like Fidelity. This impacts the influence that outsiders can have on how the company does business. Also consider the service model. Schwab is a for profit while Vanguard is basically structured like a non-profit. All of this tends to impact product and service offerings, culture, etc. A more profit-focused firm may be more aggressive in making moves that benefit its stockholders.
Looking at the bigger picture, it is most likely that this move will have the following effects on the industry at large:
By luring investors in through zero commissions, the large brokerages will benefit from idle cash balances. They will act like a bank and earn more by lending at higher rates than they pay investors on the cash.
Brokerage firms may opt to make up for some of the lost commission revenue by charging higher margin interest rates.
Brokerage firms may be incentivized to seek new sources of revenue such as selling order flow information, cross selling their own or outside products and services.
There is some speculation that zero commission trading will encourage higher trading turnover and risky behavior. While this is certainly possible, it is unlikely that most investors will opt to become day traders overnight.
What it means for us (and you!)
At Financial Alternatives, we are fiduciaries. We have a duty to ensure we are getting the best execution for our clients and to re-evaluate investment products on a periodic basis. This change certainly triggers another look.
Individual investors now have a wider range of commission-free ETF products to choose from. If you’re investing in ETFs or stocks for the first time, you need to consider the tax accounting method (FIFO, HICO, etc.) to use as this may have a major impact on your taxable income when it comes time to sell.
Additionally, if investor behavior changes, we could see more volatility in prices (and spreads) among ETFs and stocks along with the possibility of future “flash crashes” with extreme price swings.
Because of our approach to management, trading fees have been a relatively minimal cost historically. Still, we are now re-evaluating positions, and if any modifications are required, we will be in touch with clients through future communications. In the meantime, we encourage investors to maintain a long-term view that is focused on your personal circumstances and ability to handle risk - as opposed to short-term or speculative opportunities.
Contributor
Chris Jaccard, CFP®, CFA is a lead advisor with Financial Alternatives in La Jolla, CA. When he’s not working on home improvement projects or trying to keep up with his kids, he loves to help successful families consider their alternatives and make better financial choices with the EXPERT™ Advisory Process. Schedule a time to chat about your situation or the latest project.